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Volatility Smile

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The volatility smile is a graphical representation showing the implied volatility for a set of options with the same expiration date and the same underlying asset, but with different strike prices. On an x-axis represented by the strike price, the implied volatility is graphed with the corresponding implied volatility, usually the closer-dated option, on the y-axis. Typically, the graph will show an “smile” shape if the implied volatility of options at-the-money (ATM) is less than that of options in-the-money (ITM) or out-the-money (OTM).

Near-term equity options and currency-related options are more likely to have a volatility smile. This is because the events influencing their pricing are likely to differ between ITM, OTM and ATM options. For example, for equity options, investors may see greater or lower implied volatility for the options with a strike price closest to the current price of the underlying asset, as the contracts have a better chance of expiring ITM. For currency-related options, the volatility of implied volatility may come from changing exchange rates, causing farther out-the-money options to be more expensive than they would otherwise be.

It’s important to note that implied volatility is only one factor in an option’s overall price. Other factors, such as supply and demand, economic news, and speculation about future pricing may also affect an option’s overall price. As a result, traders must be aware of other factors driving an option’s price and volatility.

The volatility smile is a key concept for options traders and is therefore important to understand. A trader should be familiar with the volatility smile and be aware of what factors may lead to the volatility smile for a certain type of option. By understanding the volatility smile, traders can gain a better understanding of how to position their trades for maximum profit.

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