What Is a Volatility Smile?

02/02/2015 8:00 am EST

Focus: OPTIONS

The staff at Investopedia.com outlines the ins and outs of the volatility smile geographical pattern, specifically how it relates to option trading, including its history, when you most likely will or will not see it occur, and a number of hypotheses that explain the existence of it in the first place.

A volatility smile is a geographical pattern of implied volatility for a series of options that has the same expiration date. When plotted against strike prices, these implied volatilities can create a line that slopes upward on either end; hence the term, "smile." Volatility smiles should never occur based on standard Black-Scholes option theory, which normally requires a completely flat volatility curve. The first notable volatility smile was seen following the 1987 stock market crash.

The pricing of options is more complicated than the pricing of stocks or commodities and this is well-reflected in a volatility smile. Three main factors make up an option's value: strike price relative to the underlying asset; the time until expiration, or expiry; and the expected volatility in the underlying asset during the life of the option. Most option valuations rely on the concept of implied volatility, which assumes the same level of volatility exists for all options of the same asset with the same expiry.

Several hypotheses explain the existence of volatility smiles. The simplest and most obvious explanation is that demand is greater for options that are in-the-money or out-of-the-money as opposed to at-the-money options. Others suggest that better-developed options models have led to out-of-the-money options becoming priced more expensively to account for risk of extreme market crashes or black swans. This calls into question any investing strategy that relies too heavily on implied volatility from the Black-Scholes model, particularly with the valuation of downside puts that are far away-from-the-money.

By the staff at Investopedia.com

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