A volatility smile is a common graphic visualization of the strike prices and the implied volatility of options with the same underlying asset and expiration date. Understanding an implied volatility smile can help traders make decisions about their portfolio or certain securities.
Volatility Smile Definition
Implied volatility smiles involve the plotting of strike prices and implied volatility of a bunch of different options on a graph with levels of implied volatility and different strike prices along its axes. Each of the options plotted share the same underlying asset and expiration date. On a graph, they appear in a U shape (or a smile).
The volatility smile is a graphical pattern that shows that implied volatility for the options in question increases as they move away from the current stock or asset price.
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What Do Volatility Smiles Indicate?
When plotted out, volatility smiles illustrate different levels of implied volatility at different strike prices. So, at strike price X, the level of implied volatility would be Y, and so on. At an extremely basic level, the “smile” appearing on a chart could be an indication that the market is anticipating certain conditions in the future.
The appearance of a volatility smile could also indicate that demand is higher for options that are “in the money” or “out of the money” than it is for those that are “at the money.”
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Understanding Volatility Smiles, and How to Use Them
A volatility smile can have an effect on options prices. If a trader is considering buying or selling a new option, the chart can help the trader understand the likely pricing of that option, given its strike price and how the market values volatility at a given time. Some options (like those related to currency) have a higher likelihood of producing a volatility smile, and some options will never produce one.
Volatility Smiles and Skews and Smirks
It’s not all smiles when it comes to volatility. There are also volatility skews and volatility smirks in the mix, too.
Volatility Skew
A volatility skew, as seen on a graph, is the difference of measured implied volatility between different options at different strike prices. Basically, a skew appears when there’s a difference in implied volatility between options that are out-of-the-money, at-the-money, and in-the-money. In effect, different options would then trade at different prices.
That means a volatility smile is actually one form of a skew.
Volatility Smirk
Volatility smirks are another form of skew, except rather than having a symmetrical “U” shape, a smirk has a slope to one side.
Instead of a straight line on a graph that would indicate no difference in volatility between the in-the-money, out-of-the-money, and at-the-money options, a smirk shows three different measures of volatility depending on where in “the money” the option lands. This is different from a volatility smile in that a smile indicates that in-the-money and out-of-the-money options are at similar, if not equal, levels of implied volatility.
A smirk is commonly seen when plotting the volatility skew of equity options, where implied volatility is higher on options with lower strikes. One explanation for this phenomenon is that traders favor downside protection, and so purchase put options to compensate for risk.
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Volatility Smile Limitations
An important thing for traders to remember about volatility smiles and skews is that they are theoretical, and reality may not necessarily line up with what’s being portrayed on a graph. In other words, it’s not a fool-proof way to get a read on current market conditions.
Also, not all types of options will showcase smirks or smiles, and for those that do, those smirks or smiles may not always be so clearly defined. A volatility smile may not look like a clear-cut semi-circle — depending on the factors at play, it can look like a much rougher grin than some traders expect.
Volatility Smiles and the Black-Scholes Model
The Black-Scholes Model is a formula that takes several assumptions and inputs — strike prices, expiration dates, price of the underlying asset, interest rates, and volatility — and helps traders calculate the chances of an option expiring in-the-money. It’s a tool to help measure risk, including tail risks.
While popular with many traders for years, it fails to predict volatility smiles — exposing a flaw in its underlying assumptions. Because of that, the Black-Scholes Model may not be as accurate or reliable as previously thought for calculating volatility and corresponding options values.
The Takeaway
Experienced options traders may use volatility smiles as one tool to evaluate the price and risk of a specific asset. They’re typically used by more experienced traders who have advanced tools to help plot securities and who are comfortable trading options and other derivatives.
However, you don’t need such advanced tools to start building a portfolio. It’s possible to begin investing for your future goals without using complicated models or processes.
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