Quoting options vol into a binary drug-approval event
Asked at SIG, Citadel Securities
A small biotech awaits an FDA approval decision, a binary event that will send the stock up perhaps on approval or down on rejection. An options market maker who normally quotes a tight implied-volatility spread widens it dramatically in the days before, and pulls quotes entirely at the announcement.
Explain the mechanics in options terms. Why do vol quotes blow out, and why step away at the decision?
Show a hint
An options maker is short optionality and hedges with the underlying. Ask what a discrete, scheduled jump does to that hedge and to adverse selection.
Your answer
This one is open-ended. Work it through, then check your reasoning against the full solution.