Which option models are used in the industry?

[Dan_BR-UK]

Hello all,

Although I have found some posts with similar questions, I haven’t found an explicit answer for this.

There are so many option pricing models out there (BS, Jump Diffusion, Stochastic Vol, SVJD, Rough Volatility, etc). Can anyone tell me what types of models are actually used by market makers, buy-side traders and other industry participants?

If the answer to this question is something like “it depends on what is your goal”, can you please elaborate further and state which type of models are used for each purpose?

Thank you.

 

[Daniel Duffy]

I think the N:M:R:T question is too big to answer.

"Paul Wilmott on Quantitative Finance" Vols 1 to 3 is a good place to start.

Maybe start with 1 factor BS and take it from there.

 

[Dan_BR-UK]

Thank you, Daniel.

I am familiar with some of these from an academic standpoint. What I am actually wondering is: which models have left the paper and are actually being implemented by market participants?

It goes without saying that I have 0 industry experience with this. So I am just wondering what people are using.

 

[quanttrader]

Pretty much none -- BS to an extent, but with major grains of salt as people understand its massive limitations.

 

[Daniel Duffy]

Pretty much none -- BS to an extent, but with major grains of salt as people understand its massive limitations.

Will you tell Dan_BR-UK what *is* useful? I think you are not telling the full story.

 

[quanttrader]

Will you tell Dan_BR-UK what *is* useful? I think you are not telling the full story.

That's fair. At the last firm I worked at the model had 3 layers - one was basically a "chopped up" version of Black-Scholes that allowed different strikes to be priced on different vols. The model allowed you to change inputs like skew, kurtosis, and upwards of 50 others. The 2nd layer was American Premium, which is separate from BS, and the 3rd basically reflected extra premium allocated to tiny options, between 1-3 deltas, but it also affected every other option's price a very little bit.

 

[Daniel Duffy]

That's fair. At the last firm I worked at the model had 3 layers - one was basically a "chopped up" version of Black-Scholes that allowed different strikes to be priced on different vols. The model allowed you to change inputs like skew, kurtosis, and upwards of 50 others. The 2nd layer was American Premium, which is separate from BS, and the 3rd basically reflected extra premium allocated to tiny options, between 1-3 deltas, but it also affected every other option's price a very little bit.

Nice. Thanks.
It sounds that these are flexible software layers?

 

[Dan_BR-UK]

Thank you Daniel Duffy and quanttrader for your replies. That is exactly the type of information I was looking for.

 

[Daniel Duffy]

Thank you Daniel Duffy and quanttrader for your replies. That is exactly the type of information I was looking for.

Good to go! Good luck.