Smile transformation for price prediction
Options prices are driven by supply and demand in the market while simultaneously being bound by no-arbitrage restrictions. This makes it difficult to create models for their prediction. Petros Dellaportas and Aleksandar Mijatović use a simple time series model to propose an option price prediction algorithm that satisfies the no-arbitrage requirement and yields profitable trading strategies
Intuitively, a set of implied volatilities IVt(Ki, T), i = 1, . . . , n, allows arbitrage if and only if it is possible to trade (buy and sell) the corresponding contracts, at prices given by IVt(Ki, T), i = 1, . . . , n, and follow a self-financing trading strategy on the foreign
exchange spot rate (buy and sell the underlying currencies) in such a way that at some future time the portfolio of options and the gains from the trading strategy in aggregate have a non-negative value with certainty
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