Liquidity Considerations in Estimating Implied Volatility

Abstract

Option markets have significant variation in liquidity across different option series. Illiquidity reduces the informativeness of the price. Price information for illiquid options is more noisy, and thus the implied volatilities ( IV s) based on these prices are more noisy. In this study, we propose weighting schemes to estimate IV , which reduce the importance attached to illiquid options. The two indexes using liquidity weights are SVIX , which is a spread‐adjusted volatility index, and TVVIX , which is a traded volume weighted VIX . We find SVIX outperforms TVVIX , the conventional schemes such as the traditional VXO , or vega weights, and volatility elasticity weights. © 2012 Wiley Periodicals, Inc. Jrl Fut Mark 32:714‐742, 2012