The implied vol surface is probably the most researched topic in the derivatives world, yet we still have much to learn from this phenomena. When it comes to options, we usually apply a quantitative approach, leaving technicals and fundamentals to the other guys. Or maybe these analysis have a bigger affect than thought previously? I came across a paper by Chen/Guo/Zhou titled "Firm Fundamentals and the Cross Section of Implied Volatility Shapes" that Euan sinclair posted via tweetah the other day. Abstract: We investigate whether firm fundamentals can explain the shape of the IV curve. We show how the shape of the IV curve can vary across firms with leverage, dividend policy, cost of capital, and so on. Using options of SPX constituent companies, we show further empirically that firm fundamentals are important determinants of the IV curve even after controlling for historical vol, risk neutral slowness, kurtosis, and systematic risk ratio. Fundamentals not only provide statistically and economically explanatory power on the IV curve, but also help reconcile with some styles facts and puzzles. Now I havent read the entire paper yet, but this got my attention. I've been trading/studying options for almost a decade now and it never dawned on my brain to apply a fundamental approach to øptionality. I always knew how dividends affect calls, or how smaller companies have illiquid option chains etc etc, but never thought about a companies fundies forming the implied vol curve. Anyone have some thoughts in regards to this? Cheers!
Think of the option price as an interest rate, and you are the loan officer: you price the loan as you foresee the likelihood of risk in your borrower's future.
You opened an entire realm. Interest rates inherently are way more complicated as a derivative than single name, or indexes etc. Discount factor, maturity/tenor need to be accounted for now. Something I just learned, but I know you can trade calendarized butterflies to take advantage of this discrepancy in the surface. But there's actually a totally seperate term titled "positive/negative butterfly" which is "a shift in bond yield curve in which long and short term yields decrease/invease by a higher degree than medium term yields. This yield curve shift effectively humps the plot of the curve."
Reply to your post is inline, below: ".sigma, post: 5158526, member: 514564"]The implied vol surface is probably the most researched topic in the derivatives world, yet we still have much to learn from this phenomena. When it comes to options, we usually apply a quantitative approach, leaving technicals and fundamentals to the other guys. Or maybe these analysis have a bigger affect than thought previously? Don’t know why anyone would not consider technicals or even fundamentals for longer term ideas. I came across a paper by Chen/Guo/Zhou titled "Firm Fundamentals and the Cross Section of Implied Volatility Shapes" that Euan sinclair posted via tweetah the other day. Did not find this paper doing a Google search, but a lot of other interesting papers came up. Care to share a link? Abstract: We investigate whether firm fundamentals can explain the shape of the IV curve. We show how the shape of the IV curve can vary across firms with leverage, dividend policy, cost of capital, and so on. Using options of SPX constituent companies, we show further empirically that firm fundamentals are important determinants of the IV curve even after controlling for historical vol, risk neutral slowness, kurtosis, and systematic risk ratio. Fundamentals not only provide statistically and economically explanatory power on the IV curve, but also help reconcile with some styles facts and puzzles. Very interesting. Definately sounds like their paper is worth a read. Now I havent read the entire paper yet, but this got my attention. I've been trading/studying options for almost a decade now and it never dawned on my brain to apply a fundamental approach to øptionality. I always knew how dividends affect calls, or how smaller companies have illiquid option chains etc etc, but never thought about a companies fundies forming the implied vol curve. What is your typical holding period? If it is less than, say a month, are fundamentals that important? Anyone have some thoughts in regards to this? Cheers!
go to Euan Sinclair’s twitter it’s on his timeline I’m too lazy to post now I will though. and my timeframe is >30DTE but maybe I’ll extend that if we can get a intellectual dialogue going about exploiting fundamentally driven metrics curving the implied space.
You always brought up interesting and thought provoking topics. Where can I find the paper? I like to read it. Best to you.
I don't have a Twitter account and never visited it. So if I can use fundamentals to model IV exactly, how do I trade it? MM essentially priced to remove fundamentals from the prices (delta neutral, etc.) so there is no arbitrage?
I think the takeaway is in this paragraph on page 15/16: "The coefficients of the profitability, dividend-price and book-to-market ratios are positively significant, while the coefficient estimates are negative for the liquidity, investment, size and momentum, suggesting those fundamentals perform differently in determining the volatility smile shape, especially its symmetry. For instance, a firm with a smaller size suffers different downside and upside risk, resulting in a steeper volatility slope." Also, this paper explains that they might be the first to lay out this relationship, although I doubt market makers would miss a pattern like this if it exists. "In explaining the volatility curvature, skewness is negatively while kurtosis is positively significant. Stock with a smaller liquidity, profitability, investment, size and momentum, with a larger dividend-price ratio and book-to-market ratio has a significantly larger volatility curvature. The systematic ratio is significant in explaining the curvature" This is also important; risk, which is of course associated with fundamentals, accounts for most of the volatility smile. This is consistent with what we already know about volatility. Trading might look like this: Trading equities based on fundamentals likely to have an extreme smile at certain times should be limited to selling, equities with a shallow smile should be limited to buying. Just getting closer to the way a MM might evaluate an option, if its valid/reliable, imo