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Using Bid-Ask Quotes to Fit Option Prices in Incomplete Markets

Article Quant Q&A · Author: G2MWF
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Summary

The document explains why bid and ask quotes can matter when fitting option prices in an incomplete market. Rather than forcing a model to match each quote’s midpoint exactly, a calibration can allow model values to lie within the quoted spread. This accommodates uncertainty in observed prices and provides flexibility in fitting.

The response also notes that quoted prices may be more informative than last-trade prices for illiquid contracts, where the last transaction can be stale. Treating prices between bid and ask as acceptable is linked to no-arbitrage bounds. The discussion is brief and gives no formal calibration algorithm, mathematical derivation, or empirical comparison, so it conveys the intuition rather than a complete pricing framework.

Key ideas

  • Option calibration can allow fitted prices anywhere within the bid-ask interval.
  • Matching midpoints exactly may impose unnecessary constraints on a model fit.
  • Quoted markets can be more current than last trades in illiquid contracts.
  • The interval between bid and ask can represent prices consistent with no arbitrage.

Tags

OptionsDerivatives pricingMarket microstructure
Full text
# Why do we worry about the bid/ask spread when pricing option in incomplete market?


# Why do we worry about the bid/ask spread when pricing option in incomplete market?












Several resources I saw introduce the notion of bid/ask spread when trying to price options in incomplete market, I don't understand why the notion is introduced since we are interested on the price that will be given by the seller of the option so why considering the bid-ask spread ? To be sure that the $bid\leq ask$ ? Did I miss something ?

Thank you a lot

## Answer by Bob Jansen (score 2, accepted)

https://quant.stackexchange.com/a/71176

It allows a bit more flexibility when fitting then requiring that the prices match the mid price. Quoted prices might be preferred over last traded price as the latter could be stale for less liquid contracts. As pointed out by @nbbo2 this makes all the prices between the bid and the ask no-arbitrage prices.

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