Option Pricing Via Breakeven Volatility

Abstract

The fair value of an option is given by breakeven volatility, the value of implied volatility that sets the profit and loss of a delta-hedged option to zero. We calculate breakeven volatility for 400,000 options traded on the S&P 500 Index, and we build a predictive model for these volatility values. A two-stage regression approach captures the majority of observed variation. By providing a link between option characteristics, such as moneyness and time to expiration, and breakeven volatility, we establish a nonparametric approach of pricing options without the need to specify the underlying price process. We illustrate the economic value of our approach with a simulated trading strategy based on model predictions of breakeven volatility.