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Why OTM Calls and Puts Are Modeled Together in Volatility Analysis

Article Quant Q&A · Author: Chandler Bing
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Summary

The document asks why volatility models often treat out-of-the-money calls and puts as a group even though their implied volatilities can differ. It identifies liquidity as a reason for focusing on OTM contracts and notes that OTM puts commonly carry higher implied volatility, reflecting demand for downside protection. It raises the possibility that pooling the two option types could obscure signals that are specific to calls or puts.

The text frames these as questions rather than supplying a modeling method, professional practice, or empirical evidence. It does not explain how to account for skew, fit separate volatility surfaces, or measure the effect of joint modeling on strategy accuracy. The practical takeaway is that liquidity advantages should be weighed against call-put asymmetry; the document itself leaves that trade-off unresolved.

Key ideas

  • OTM options are often considered because they tend to have high liquidity.
  • OTM puts may have higher implied volatility than OTM calls, consistent with demand for downside protection.
  • Combining calls and puts in one model could obscure option-type-specific signals.
  • The document raises modeling questions but does not provide evidence or a resolution.

Tags

OptionsVolatilityDerivatives pricing
Full text
# Why Are OTM Calls and Puts Often Modeled Together Despite Differences in IV?


# Why Are OTM Calls and Puts Often Modeled Together Despite Differences in IV?












In the modeling of options, particularly for trading strategies, I've noticed that both OTM calls and OTM puts are frequently considered together. While I understand that OTM options generally exhibit the highest liquidity, I am questioning the rationale behind jointly modeling OTM puts and calls, especially when their implied volatility (IV) behaviors differ significantly.

Liquidity Considerations: It's clear that OTM options are more liquid, but why does this justify modeling calls and puts together? Is the liquidity benefit strong enough to outweigh the differences in their market behaviors?

IV Discrepancies: Typically, OTM puts show higher IVs compared to OTM calls, a reflection of the market's risk aversion (higher premium for downside protection). How does combining these into a single model affect the accuracy and responsiveness of trading strategies?

Modeling Impact: Could modeling these options together potentially mask important signals that are specific to either calls or puts? How do professionals adjust their models to account for the distinct characteristics of OTM puts and calls?

I am keen on understanding both the theoretical and practical perspectives that justify the common practice of jointly modeling these option types. Insights from those experienced in volatility modeling and options trading would be greatly appreciated.

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.