What Is a Volatility Smile?
Let me explain what a volatility smile is. It's that familiar graph shape you get when you plot the strike price against the implied volatility for a set of options that all have the same underlying asset and expiration date. It gets its name because the curve looks like a smiling mouth. You'll see implied volatility increasing as the underlying asset moves further out of the money or in the money, compared to when it's at the money. Keep in mind, though, that not every option exhibits this volatility smile.
Key Takeaways on Volatility Smiles
When you graph implied volatility for options with the same expiration and underlying but different strikes, you often end up with that smile shape. This smile indicates that the deepest in-the-money or out-of-the-money options carry the highest implied volatility. On the flip side, options with strike prices at or near the money show the lowest implied volatility. Not all options follow this pattern—near-term equity options and those tied to currencies are more prone to it. Even a single option's implied volatility can mimic the smile as it shifts more in or out of the money. Remember, implied volatility is just one piece of options pricing; you need to consider other factors influencing price and volatility.
What Does a Volatility Smile Tell You?
A volatility smile forms because implied volatility changes as the underlying asset drifts more in the money or out of the money. The further an option is in either direction, the higher its implied volatility climbs, while at-the-money options typically have the lowest. This isn't what the Black-Scholes model predicts—that model expects a flat implied volatility curve across strike prices. According to Black-Scholes, all options with the same expiration and underlying should have identical implied volatility, no matter the strike. But reality doesn't match that.
These smiles started showing up in options pricing after the 1987 stock market crash. Before then, U.S. markets aligned more with Black-Scholes, without the smile. Post-1987, traders acknowledged that extreme events can occur, introducing significant skew to markets. Options pricing had to account for these possibilities, so implied volatility adjusts as options move more in or out of the money.
The presence of a volatility smile also signals that in-the-money and out-of-the-money options are often in higher demand than at-the-money ones. Demand pushes prices, which in turn affects implied volatility. This demand might stem partly from the risk of extreme events causing big price swings, which gets baked into the volatility figures.
Example of How to Use the Volatility Smile
You can spot volatility smiles by comparing options with the same underlying and expiration but varying strike prices. Plot their implied volatilities, and you might see a U-shape—not always perfect, but there. For a quick check, look at an options chain listing implied volatilities by strike. If it's a U-shape, options equally in or out of the money should have similar volatilities, increasing as they get further from at-the-money, where volatility is lowest. If not, it doesn't fit the smile.
You could also track a single option's implied volatility over time against the underlying's price. As it moves in or out of the money, the volatility might form a U-shape. This helps if you're hunting for lower volatility—pick near-the-money options. For higher volatility, go further in or out. But watch out: as the underlying shifts relative to the strike, volatility changes, so you'd need to adjust your portfolio regularly to maintain a target volatility.
Not every option follows the smile, so verify it before basing trades on this model.
The Difference Between a Volatility Smile and a Volatility Skew or Smirk
While near-term equity and forex options often match a volatility smile, index options and long-term equity options usually follow a volatility skew or smirk. In a skew or smirk, implied volatility might be elevated for either in-the-money or out-of-the-money options, not symmetrically like in a smile.
Limitations of Using the Volatility Smile
First, confirm if your option actually fits the volatility smile pattern. It might align better with a reverse or forward skew instead. Market factors like supply and demand can distort the smile, making it less than a clean U-shape—choppy, with some options showing unexpected volatility levels.
The smile points you toward higher or lower volatility spots, but don't forget other elements in options trading decisions.
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