Option Pricing Via Breakeven Volatility

Abstract

The fair value of an option is given by breakeven volatility, the value of implied volatility that sets the profit-and-loss of a delta-hedged option to zero. We calculate breakeven volatility for 400,000 options on the S&P 500 and build a predictive model for these volatilities. A two-stage regression approach captures the majority of observed variation. By providing a link between option characteristics and breakeven volatility, we establish a nonparametric approach of pricing options without the need to specify the underlying price process. We illustrate the economic value of our approach with a simulated trading strategy based on breakeven volatility predictions.

Keywords: options, volatility, prediction, trading strategy

JEL Classification: G10, G11, G13, C14