Weighting Strategies

You can use options models to derive the implied underlying price and implied volatility by weighting strategies.

The selected options model with all inputs except underlying price is seeded as a start value. Next, the system uses a search algorithm to find the underlying price that satisfies the option value observed in the market. This is the same method used to find implied volatility. For average implied values, there are a number of averaging methods that may be employed.

2. Click Weights. The Implied Value Averaging Method window opens. The current order of values is displayed on the window.

Volume Weighted Averaging Method

This method places the greatest emphasis on contract with the greatest daily volume. The greater the volume traded for the option in question, the more weight is given to the option’s implied value. When using this method, one assumes that the current trading activity is most relevant in a determination of market behavior. Specifically, for n number of trades, each with a separate open interest, the method would be used as follows:

Variable	Definition
VOL1	Volume for trade 1
VOL2	Volume for trade 2
VOLn	Volume for trade n
UP1	Implied underlying price for trade1
UP2	Implied underlying price for trade 2
UPn	Implied underlying price for trade n
AUP	Average implied underlying price for the strategy
TOI	Total open interest for all trades.

The average is the sum of each implied underlying price for each trade weighted by its proportion of the total volume for all trades:

AUP = [VOL₁/(AUP * UP₁)] + [VOL₂/(AUP * UP₂)] + [VOL_n/(AUP * UPn)]

Open Interest Weighted Averaging Method

This method places emphasis on open interest for the option contract. More weight is given to the implied values derived from options with the greatest open interest. An underlying assumption when using this method is that the interest in a contract requires holders of that contract to adjust their positions in accordance with their market expectations. A large open interest on a low volume suggests that the contract holders are satisfied that the option is correctly valued in the market and that adjustments are not in order. Therefore, volume is not required to justify the importance of the contract with respect to the market. Specifically, for n number of trades, each with a separate open interest, the method would be used as follows:

Variable	Definition
OI1	Open interest for trade 1
OI2	Open interest for trade 2
Oln	Open interest for trade n
UP1	Implied underlying price for trade1
UP2	Implied underlying price for trade 2
UPn	Implied underlying price for trade n
AUP	Average implied underlying price for the strategy
TOI	Total open interest for all trades.

The average is the sum of each implied underlying price for each trade weighted by its proportion of the total open interest for all trades:

AUP = [OI₁/(AUP * UP₁)] + [OI₂/(AUP * UP₂)] + [OI_n/(AUP * UPn)]

Price Weighted Averaging Method

This method places the greatest emphasis on the series that is closest to at-the-money. The closer the option strike is to at-the-money, the more weight is given to the implied value from the option. Conversely, the further out-of-the-money the strike is, the less weight is given to the implied value from the option. For example:

Strike Price Identifier	Strike	Underlying Price (UP)	Strike - UP	Volatility
Trade 1	2000	2250	250	20
Trade 2	The lowest strike for the strategy.	2250	150	22
Trade 3	2200	2250	50	24
Trade 4	2300	2250	50	26

-----In other words, the sum of column 4. = 500

Sum2 = = (500 – 250) + (500 – 150) + (500 – 50) + (500 – 50) = 1500

Price Weighted Average Implied Volatility = * Volatility

Therefore, Price Weighted Average Implied Volatility =

3.33 + 5.13+ 7.2 + 7.8 = 23.46

This method is most useful for averaging Implied Volatilities. For averaging Implied Underlying Prices this makes less sense, since the proximity of a strike to the underlying price is in doubt.