Keep on Smiling: Market Imbalance, Option Pricing, and the Volatility Smile

19 Pages Posted: 17 Sep 2022 Last revised: 2 Jan 2023

Date Written: August 31, 2022

Abstract

The Black-Scholes model, which is widely used to price financial options, assumes that volatility is constant as a function of strike price. However when market option prices are used to infer the volatility that is implied by those prices, it often exhibits a marked dependence on strike price which is characterised by a smile or skew shape. This paper argues that the volatility smile is “real” in the sense that volatility and price change are correlated through the degree of market imbalance. We test a formula for the volatility smile, derived from a quantum oscillator model of stock markets, against historical market data. It is seen that the Black-Scholes model systematically misprices options, but that option pricing performance can be improved by taking the smile into account.

Keywords: financial options, implied volatility, stock markets, quantum economics, quantum finance

JEL Classification: G10, G12

Suggested Citation

Orrell, David and Richards, Larry, Keep on Smiling: Market Imbalance, Option Pricing, and the Volatility Smile (August 31, 2022). Available at SSRN: https://ssrn.com/abstract=4205729 or http://dx.doi.org/10.2139/ssrn.4205729

David Orrell (Contact Author)

Systems Forecasting ( email )

Canada

HOME PAGE: http://www.systemsforecasting.com

Larry Richards

Gammon Capital ( email )

175 Varick St 8th floor
New York, NY 10014
United States
10014 (Fax)

HOME PAGE: http://www.gammoncap.com/

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