Volatility Smile

AAA

DEFINITION of 'Volatility Smile'

A common graphical shape that results from plotting the strike price and implied volatility of a group of options with the same expiration date. The volatility smile is so named because it looks like a person smiling. The implied volatility is derived from the Black-Scholes model, and the volatility adjusts according to the option’s maturity and the extent to which it is in-the-money (moneyness).

BREAKING DOWN 'Volatility Smile'

Changes in an option’s strike price affect whether the option is in-the-money or out-of-the-money. The more an option is in-the-money or out-of-the-money, the greater its implied volatility becomes. The relationship between an option’s implied volatility and strike price can be seen in the graph below.

 

 

Volatility Smile

 

The volatility smile is used in the analysis of a number of investments. It cannot be directly observed in over-the-counter foreign exchange markets, though investors can use at-the-money volatility and risk data for specific currency pairs to create a volatility smile for a specific strike price. Equity derivatives show both price and volatility pairs, allowing the smile to be created relatively easily.

The volatility smile was first seen after the 1987 stock market crash, and was not present before. This may be the result in changes in investor behavior, such as a fear of another crash or black swan, as well as structural issues that go against Black-Scholes option pricing assumptions. 

RELATED TERMS
  1. Volatility Skew

    The difference in implied volatility (IV) between out-of-the-money, ...
  2. At The Money

    A situation where an option's strike price is identical to the ...
  3. Option

    A financial derivative that represents a contract sold by one ...
  4. Implied Volatility - IV

    The estimated volatility of a security's price. In general, implied ...
  5. Black Scholes Model

    A model of price variation over time of financial instruments ...
  6. In The Money

    1. For a call option, when the option's strike price is below ...
Related Articles
  1. Options & Futures

    Options Basics Tutorial

    Discover the world of options, from primary concepts to how options work and why you might use them.
  2. Home & Auto

    Understanding Rent-to-Own Contracts

    They can work for you or against you. Here's how to negotiate a fair one.
  3. Home & Auto

    Avoiding the 5 Most Common Rent-to-Own Mistakes

    Pitfalls that a prospective tenant-buyer could encounter on the road to purchase – and how not to stumble into them.
  4. Home & Auto

    Renting vs. Owning: Which is Better for You?

    Despite the conventional wisdom, renting might make more financial sense than you think.
  5. Investing Basics

    Explaining Options Contracts

    Options contracts grant the owner the right to buy or sell shares of a security in the future at a given price.
  6. Home & Auto

    When Are Rent-to-Own Homes a Good Idea?

    Lease now and pay later can work – for a select few.
  7. Home & Auto

    When Getting a Rent-to-Own Car Makes Sense

    If your credit is bad, rent-to-own may be a better way to purchase a car than taking out a subprime loan – or it may not be. Get out your calculator.
  8. Options & Futures

    An Introduction To Value at Risk (VAR)

    Volatility is not the only way to measure risk. Learn about the "new science of risk management".
  9. Investing

    Looking To Begin Trading In The Stock Market?

    If you are a new trader, we explain the differences between penny stocks and options so you can make the best decision for your personal trade plan.
  10. Options & Futures

    How to Trade Options on Government Bonds

    A look at trading options on debt instruments, like U.S. Treasury bonds and other government securities.
RELATED FAQS
  1. What is a volatility smile?

    A volatility smile is a geographical pattern of implied volatility for a series of options that has the same expiration date. ... Read Full Answer >>
  2. How does a forward contract differ from a call option?

    Forward contracts and call options are different financial instruments that allow two parties to purchase or sell assets ... Read Full Answer >>
  3. What are the main risks associated with trading derivatives?

    The primary risks associated with trading derivatives are market, counterparty, liquidity and interconnection risks. Derivatives ... Read Full Answer >>
  4. How can an investor profit from a fall in the utilities sector?

    The utilities sector exhibits a high degree of stability compared to the broader market. This makes it best-suited for buy-and-hold ... Read Full Answer >>
  5. What is the difference between derivatives and options?

    Options are one category of derivatives. Other types of derivatives include futures contracts, swaps and forward contracts. ... Read Full Answer >>
  6. How are rights distributed in a rights offering?

    In a rights offering, rights are distributed to shareholders based on the number of shares they already own. What Is a Rights ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Stock Market Crash

    A rapid and often unanticipated drop in stock prices. A stock market crash can be the result of major catastrophic events, ...
  2. Financial Crisis

    A situation in which the value of financial institutions or assets drops rapidly. A financial crisis is often associated ...
  3. Election Period

    The period of time during which an investor who owns an extendable or retractable bond must indicate to the issuer whether ...
  4. Shanghai Stock Exchange

    The largest stock exchange in mainland China, the Shanghai Stock Exchange is a nonprofit organization run by the China Securities ...
  5. Dead Cat Bounce

    A temporary recovery from a prolonged decline or bear market, followed by the continuation of the downtrend. A dead cat bounce ...
  6. Bear Market

    A market condition in which the prices of securities are falling, and widespread pessimism causes the negative sentiment ...
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!