The Vanna-Volga method is a sophisticated option pricing and hedging technique that corrects the Black-Scholes model by accounting for the implied volatility smile or skew observed in market prices. This method uses market prices of a few liquid options to calibrate a local volatility model, specifically incorporating the ‘vanna’ and ‘volga’ sensitivities. Its purpose is to provide more accurate pricing and risk management for exotic or illiquid options, especially in markets exhibiting non-normal price distributions.
Mechanism
The mechanism involves constructing a volatility surface that is consistent with observed market prices for benchmark options, typically at-the-money and a few out-of-the-money calls and puts. Using these calibrated volatilities, the Vanna-Volga method then applies a perturbation approach to adjust the Black-Scholes price for other options, specifically those that are off-market or have different maturities. This adjustment incorporates the higher-order Greeks to capture the curvature of the volatility smile.
Methodology
The methodology applies a semi-analytical approach, typically involving a small number of liquid options as calibration points to derive implied volatilities that locally adjust the diffusion process. For crypto institutional options trading, where implied volatility surfaces can be particularly steep and dynamic, the Vanna-Volga method offers a pragmatic way to price and hedge complex options positions more accurately than simpler models, particularly when managing gamma and vega risks across various strikes and expirations.
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