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 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.