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 based on these prices are more noisy. In this paper, we propose a scheme to estimate
implied volatility which reduces the importance attached to illiquid options. We find that this liquidity
weighted scheme outperforms conventional schemes such as the traditional vxo, or vega weights, and
volatility elasticity weights.
