Skip to content
All library documents

Stabilizing Option Skew Inputs for Portfolio Risk Scenarios

Article Quant Q&A · Author: tjf
Read the original

Summary

The document discusses real-time risk estimates for US equity option portfolios when implied volatility is unreliable at deep in-the-money or out-of-the-money strikes. The questioner describes deriving volatility from current market prices, then revaluing options across underlying price shocks. Short-dated contracts, wide spreads, and options without bids can produce inconsistent call and put implied volatilities, which can distort deltas and portfolio risk, particularly for dividend-related reversals and conversions.

The response recommends excluding deep in-the-money prices because they tend to be less liquid, using higher-strike calls and lower-strike puts to inform the skew. For risk and scenario valuation, it suggests capping volatility using the highest mid-market volatility among puts with both a bid and an offer. The response cautions that this simplified skew is suitable for risk estimates, not market making. It does not provide a full curve-fitting procedure or demonstrate performance against alternative methods, so the suggested cap remains a practical heuristic rather than a validated universal model.

Key ideas

  • Deep in-the-money option quotes can be unreliable because they are often less liquid.
  • Use higher-strike calls and lower-strike puts to build a more stable skew input.
  • A volatility cap based on quoted puts with both a bid and an offer can moderate extreme estimates.
  • A simplified capped skew may suit risk scenarios but is not presented as suitable for making markets.

Tags

OptionsVolatilityRisk managementDerivatives pricingEquities
Full text
# Option Portfolio Risk - Volatility/Skew - practical implementation


# Option Portfolio Risk - Volatility/Skew - practical implementation












I'm trying to improve my methods for calculating real-time US Equity option portfolio risk. My main problem is volatility "stability" across all strikes in an option series.

The current implementation is similar to the OCC Haircut calculations, where I calculate volatility at current market prices and then calculate theoretical prices for all options at 10 equidistant percentage moves of the underlying up and down.

My problem is generally with deep ITM/OTM options that have a short time to maturity and/or wide bid-ask spreads, no bids, etc. I often see call vs. put IV's severely out of whack which in turn causes deltas to be incorrect (especially for portfolios that do large reversals/conversions for dividend plays). I'm using a dividend forecast feed in my current pricing models (Escrow method).

I was wondering if it would be better to extrapolate the skew curve from the ATM options to estimate volatility at further strikes? Are there any programmatic examples out there that describe and handle this situation?

Thanks!

## Answer by Brian B (score 5, accepted)

https://quant.stackexchange.com/a/2306

Generally, you should ignore deep in-the-money option prices because they are far less liquid (due to their low leverage). That lets you use just the calls on the high strikes and just the puts on the low strikes.

For your purposes, you can cap the volatility at, say, the highest mid-market volatility of all puts having both a bid and an offer. This cut-off to the skew will keep your valuations and risk fairly sane.

You would not want to make markets off such an ugly skew but it is OK for doing risk and scenarios.

For a more involved approach, see here:

Is there a popular curve fitting formula of options skew vs strike price or vs Delta?

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.