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Abstract

One of the most widely used option valuation models among practitioners is the ad hoc Black–Scholes (AHBS) model. The main contribution of this study is methodological. We carefully consider two rollover strategies (nearest-to-next strategy and next-to-next) used in the AHBS model to investigate their effect on pricing errors. We suggest a new rollover strategy, next-to-next strategy, and demonstrate that our rollover strategy produces more consistent estimates between in-sample market and model option prices. Probably even more important is that our new rollover strategy makes more accurate out-of-sample forecasts for 1-day or 1-week ahead prices. Prior literature has documented some anomalies associated with the use of AHBS model, for example, an overfitting problem. A secondary contribution is that our new rollover strategy does not suffer from this overfitting critique. Third, this study uses the mean square error for out-of-sample pricing and price changes to determine how the options investors are influenced by moneyness. The results indicate that underpricing (or overpricing) by the AHBS model for the near-the-money category is more likely to be maintained for the next several trading days but that such a phenomenon is disappeared for the deep out-of-the-money category. Finally, we suggest the ratio of the number of option contracts to differences in strike prices available for trading between the current day and the previous day(s) as a good categorizing factor for options, such as moneyness. © 2011 Wiley Periodicals, Inc. Jrl Fut Mark