A volatility smile is a fascinating and common graph shape that emerges when plotting the strike price against the implied volatility of a series of options with the same underlying asset and expiration date. Named for its resemblance to a smiling face, this graph reveals crucial insights into market behaviors related to option pricing.
Key Takeaways
- When options with the same expiration date and underlying asset but different strike prices are graphed, the resulting shape usually resembles a smile.
- This smile indicates that options furthest in the money (ITM) or out of the money (OTM) have higher implied volatility.
- Options closest to at the money (ATM) display the lowest implied volatility.
- Volatility smiles are more common in near-term equity and currency-related options.
- A single option’s implied volatility profile may also develop a U-shape as it shifts ITM or OTM over time.
- Traders should consider factors beyond implied volatility to make informed options pricing decisions.
What Does a Volatility Smile Tell You?
Volatility smiles originate from varying implied volatility levels as underlying assets shift more ITM or OTM. Generally, implied volatility is lowest for ATM options. This phenomenon wasn’t anticipated by the Black-Scholes model, a widely-used formula in options pricing that predicts a flat implied volatility curve against varying strike prices.
The 1987 stock market crash was a turning point, after which traders acknowledged the market’s potential for extreme events. This realization skewed volatility expectations and contributed to the formation of volatility smiles, showing increased implied volatility for extreme price movements.
Volatility smiles also suggest higher demand for ITM and OTM options compared to ATM options, influenced by traders’ anticipation of significant market shifts.
Example of How to Use the Volatility Smile
Image by Julie Bang © 2019
To observe a volatility smile, one can compare various options with the same underlying asset and expiration date but differing strike prices. By plotting the implied volatility for each strike price, you might notice a U-shaped curve appearing.
A quick way to gauge this pattern is by examining an options chain displaying implied volatilities for different strike prices. If implied volatilities form a U-shape, with higher volatilities for ITM and OTM options, the pattern fits the characteristics of a volatility smile.
Traders aiming for lower implied volatility should opt for ATM options, whereas those seeking to leverage higher implied volatility might consider further ITM or OTM positions. Awareness of the underlying asset’s price movements and their effects on implied volatility is crucial for maintaining a balanced options portfolio.
The Difference Between a Volatility Smile and a Volatility Skew/Smirk
While near-term equity options and forex options are likely to exhibit a volatility smile, index and long-term equity options typically align more with a volatility skew, showing that implied volatility is higher for ITM or OTM options.
Limitations of Using the Volatility Smile
To utilize the volatility smile effectively, first verify if the option follows this model. Implied volatility may instead align with a reverse or forward skew. Additionally, due to market factors like supply and demand, the U-shape might not be perfectly smooth but rather choppy, with some options deviating from the expected pattern.
Although the volatility smile highlights potential levels of implied volatility across strikes, traders must consider other crucial factors for a comprehensive trading decision.
Related Terms: implied volatility, options expiration, options chain, Black-Scholes model, volatility skew, options trading strategies
References
- Luca Benzoni, Pierre Collin-Dufresne, and Robert S. Goldstein. “Explaining Asset Pricing Puzzles Associated with the 1987 Market Crash”, Page 1. Journal of Financial Economics, September 2011.
