Think Like a Market Maker — Understanding Implied Volatility

  1. Liquidity
  2. The weekend effect
  3. Seasonality
  4. Economic/Earning calendar
  5. Hedging flows

Liquidity

The Weekend Effect (aka. weekend premium)

  1. Implied volatility discount over weekends/holidays
  2. Price discontinuity (weekend gap)

Implied volatility discount

Seasonality

Economic/Earning Calendar

  1. Rank the different economic data releases by importance. For me, monetary policy-related events like CPI, labor market, and CB meetings are the most important, followed by growth data (like GDP and Retail sales) and economic activity (PMIs).
  2. Calculate the historical weights for "event days" volatility. That can be done using the ratio between the 1-day volatility (or the average between the 1-day OHLC volatility and the 1-day volatility the next day, as the market digests the data) and the realized vol of the reference period prior to the data release (can be either 1-week,2-week realized volatility ex. the event). One can use conditional volatility to better estimate the probability distribution (given an upward/downward surprise).
  3. apply the weighted-average "event-weight" for each event to the future economic calendar

Hedging flows

  1. The level of the front end ATM volatility level (relative to realized volatility)
  2. The shape of the volatility term-structure
  3. The shape of the volatility smile/skew (and implied/risk-neutral probability density)

ATM volatility level

The shape of the volatility term structure

The shape of the volatility skew/smile

A toy model to evaluate implied volatility.

  1. The average "clean" realized vol of the recent Nth days (by clean, I mean realized vol of days that had no scheduled eco events) — We can use a combination of intraday (high-frequency) / Close-Close vol to get the average vol.
  2. The scheduled data releases and their calculated weights — for example, If we have in our future term 2 CPI releases, and currently we value the weight as 2, we will assign the CPI a factor of 4 (N*W, where N is the number of events and W is the weight)
  3. The seasonality factor for the expiration month of the year
  4. The liquidity factor — -The more liquid our underlying, the lower the factor. IRL, the liquidity will also affect the bid-ask spread the market-maker will apply to the mid volatility
  5. The number of calendar days (not business days) in our term

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