This is a great post. Im curious if these techniques are widely used in hedge funds/prop shops today. I was an equity options trader many moons ago, and the Chicago prop shop I traded at generally had every trader using a simple vol arb approach. Apart from real time vol calculations per strike in the trading tools using black scholes and historical vol for the equity, nothing more complex was used to execute trades (eg no stochastic vol or jump diffusion). The concept of smiles was understood, so people would generally trade at the money options exclusively. Positions were delta hedged over night, generally at market close. Deep out of the money options were used essentially for gambles. Vega was the main source of edge, and as you can imagine, most traders exited positions once their options drifted in or out of the money since our vol model didn't really account for it.
I should say that it's always amazing to me how good traders are often quite ahead of the models: they use them and have an intuitive feel for them, but are also aware of their limitations, idiosyncrasies, and where the real world diverges from them.
(On the flip side, btw, that means that you can't blame the financial crisis on "oh, the models were bad". They were (some of them), but everyone knew. That things went on as they did was more due to systemic/political factors, incentives, etc.)
