How to improve your option pricing accuracy

The importance of accuracy

Improving pricing accuracy is one of the best ways to improve your Volcube trading performance. The most common mistake for newcomers is to rely too heavily on their theoretical values and not to adjust to changing market conditions fast enough. Take your time then to learn how to adjust correctly and accurately for changes in volatility and skew, using the vega of the strategy. There are several useful articles and videos on this subject in the Learning environment, so make sure you understand the theory fully.

By accuracy, in Volcube we mean how closely your quotations for options or option strategies matches the market value of those options. For instance, suppose your theoretical value for an option call spread is 1.42 but you suspect the market value of the spread is 1.45. In a game, you show a quote of 1.40 bid, at 1.50 offered. This would be a perfectly accurate price, because the mid-price of your quote is exactly equal to the market value. In determining accuracy, Volcube checks the mid-price of your quote against the market value. It also adjusts for the vega of the strategy; the lower the vega, the closer your mid-price must be to the market value to achieve the same level of accuracy. This is because ‘missing the value’ by 1 cent is not a big deal if the vega is large. But if the vega is low (say 1 vega) then that miss is relatively large. To learn more, check out the Volcube Blitz videos in the Learning environment of the application.

Use the Market Mentor

There are several ways to test yourself and monitor your progress. One is to use the Volcube Market Mentor to tell you the Market Value of the strategy. Use this device sparingly and always having first made up your made for yourself what you feel the true market value of the strategy is. Never unthinkingly use the Market Mentor to simply give your the ‘answer’ and make your pricing more accurate. If you are consistently inaccurate in your estimate of market value compared to the Market Mentor indication, this suggest you are not following the flow of implied volatility. Take your time and go back over the previous trades and orders. You should start to ‘feel’ the movement in implied volatility.

Use the Pricing Accuracy Metric

Use the Volcube Pricing Accuracy Metric. This tells you directly how accurate your pricing is and monitored over time, you should start to see an improvement. If not, try testing yourself more frequently using the Market Mentor in-game indicator. The Performance tab in the Analysis section after your trading games shows you on a quote-by-quote basis how accurately you priced the options in question. Look for quotes where your accuracy was low and try to understand where you went wrong. Essentially, inaccuracy is usually a misconception on your part as to where the true market value of an option (or option strategy) lies relative to your theoretical value for the option (or strategy).

Follow the order flow. For every order you see from the broker, quickly calculate what this means in implied volatility terms. By tracking the movement in implied volatility via the order flow, you are more likely to make accurate prices.

Have a question for the author? Happy to help! Email [email protected].

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