Explanation:
To accurately mark to market a book of options, a trader must take the volatility smile into account. This requires pricing each option using the implied volatility of the most similar traded option (i.e., using the market's implied volatility for the specific strike and maturity). Using historical volatility, average volatility, or a flat at-the-money volatility curve ignores the volatility smile (skew) and will lead to an incorrect valuation of the book, misrepresenting actual market prices.
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Q.46 A trader wishes to mark to market a book of plain-vanilla stock options in his portfolio. The trader is long at-the-money call options and short deep out-of-the-money call options. Given that the trader’s bonus increases as the value of his book increases, and that there’s a pronounced smile on these options, which of the following approaches should the trader use to mark the book?
A
Use the historical volatility so as to make corrections for pricing mistakes inherent in the option market
B
For each option, use the implied volatility of the most similar option tradable on the market
C
Use the average of the implied volatilities for the traded options for which the trader has data since all options should have the same implied volatility with Black-Scholes
D
Use the implied volatility of at-the-money options since volatility estimation is more reliable
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