On Trading American Put Options with Interactive Volatility

Abstract

We introduce a simple stochastic volatility model, whose novelty consists in taking into account hitting times of the asset price, and study the optimal stopping problem corresponding to a put option whose time horizon (after the asset price hits a certain level) is exponentially distributed. We obtain explicit optimal stopping rules in various cases one of which is interestingly complex because of an unexpected disconnected continuation region. Finally, we discuss in detail how these stopping rules could be used for trading an American put when the trader expects a market drop in the near future.

arXiv commentimproved version (minor corrections), 28 pages, 6 figures