What is the Best Underlying Price to Price Options?

What is the Best Underlying Price to Price Options?

The two big unknowns in pricing an option are implied volatility and the underlying price. Much time and effort is spent modeling implied volatility, and rightly so, for it is an important source of trading edge and long-term profitability. However, relatively little effort is spent thinking about the underlying price. Over short-time scales, getting the underlying price “right” may be just as important, if not more so, than capturing changes in implied volatility.

Think about this for a moment. In the “seconds” timeframe, what is more volatile – volatility or the underlying price? What is more likely to cause a market maker to refresh or pull his or her quotes?

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