Why Option Markets Quote Implied Volatility Instead of Dollar Prices
Summary
The document explains a practical reason dealers may quote vanilla options in implied volatility rather than in currency amounts. Option prices depend on several inputs, including the underlying or futures price, rates, volatility, and the shape of the volatility surface. Since the underlying price can move substantially while a quote is being discussed and confirmed, a dollar premium may quickly become stale.
A dealer can hedge much of the option’s directional exposure through delta hedging, making implied volatility a useful quoted risk measure and a relatively stable basis for negotiation in the described setting. Other pricing exposures, including rates and spot-volatility relationships, may be reflected in the volatility quote. The explanation is market-practice reasoning, not a universal theoretical rule: quoting conventions differ across markets, pricing models, and products, and the relative stability of volatility depends on the instrument and market conditions.
Key ideas
- Option premiums respond to the underlying price, rates, implied volatility, and surface shape.
- Underlying price moves can make dollar option quotes change during negotiation and execution.
- Delta hedging can reduce directional exposure and support quoting options in implied volatility.
- Implied-volatility quoting is a practical convention rather than a universal theoretical requirement.
- Markets can use different pricing models and transformations between volatility and premium.
Tags
Full text
# Citable source: Why implied volatility over dollar prices # Citable source: Why implied volatility over dollar prices I am aware of the reasoning of quoting vanilla options as implied volatilities rather than dollar values. However, I would like to have a literature reference where this is explained, to quote / cite in a thesis. I have gone through all books that I have and searched the internet for quite some time but I was unable to find a citable source - which surprises me, since this is such a fundamental consideration. I would be grateful if somebody could point me to a good book or paper that includes at least a paragraph on this. Best regards ## Answer by closedloop (score 2) https://quant.stackexchange.com/a/19426 I don't believe you will necessarily find a cite-able source as, I believe, this comes from a practical rather than theoretical motivation. As you know option prices are a function of: future prices, discount rates and implied volatility, volatility surface skew and other supple/demand factors. So when you are trading these instruments, you need to understand how all of these factors are moving over the course of pricing, the option, getting quotes and confirming the trades. (Note: for some OTC options this can take several hours). By far the most volatile component driving an options price on given day (assuming the option isn't expiring soon) is the futures prices. Given that the option's delta can be hedged out for little transaction cost, dealers prefer to quote in implied volatility as that is the second biggest driver of prices; it will also be somewhat stable over the course of pricing and confirming the trade. The pricing risk associated with other factors such as discount-rate risk and some local spot-vol correlation risk are usually incorporated into the vol quote you are given. However there these effects on the prices are usually minimal over the course of an hour. Different markets will agree on different transformations between implied vols and spot dollar prices. Some markets use Black-Scholes Formula, in others more complex formulas can be used such as Stochastic-Local Volatility.
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.