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).

INVESTOPEDIA EXPLAINS '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. Black Scholes Model

    A model of price variation over time of financial instruments ...
  4. Implied Volatility - IV

    The estimated volatility of a security's price. In general, implied ...
  5. Expiration Date (Derivatives)

    The last day that an options or futures contract is valid. When ...
  6. In The Money

    1. For a call option, when the option's strike price is below ...
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. Why would a company issue a rights offering?

    Companies most commonly issue a rights offering to raise additional capital. A company may need extra capital to meet its ... Read Full Answer >>
  3. What is the difference between share purchase rights and options?

    There is a big difference between share purchase rights and options. With share purchase rights, the holder may or may not ... Read Full Answer >>
  4. What is the difference between an option-adjusted spread and a Z-spread in reference ...

    Unlike the Z-spread calculation, the option-adjusted spread takes into account how the embedded option in a bond can change ... Read Full Answer >>
  5. In what ways can a sinking fund affect bond returns?

    The effective yield of a bond sinking fund to an investor should not be considered similar to a bond nonsinking fund. Both ... Read Full Answer >>
  6. Can delta be used to calculate price volatility of an option?

    The delta of an option is a component of the Black-Scholes option pricing formula, which provides the implied volatility ... Read Full Answer >>
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. Investing

    What More Volatility Means For Momentum Stocks

    One byproduct of the recent tick higher in bond yields: a meaningful rise in volatility for both stocks and bonds.
  3. Options & Futures

    How & Why Interest Rates Affect Options

    The Fed is expected to change interest rates soon. We explain how a change in interest rates impacts option valuations.
  4. Investing Basics

    Understanding Notional Value

    This term is commonly used in the options, futures and currency markets because a very small amount of invested money can control a large position.
  5. Options & Futures

    The Risks Of Writing Covered Calls

    While writing a covered call option is less risky than writing a naked call option, the strategy is not entirely riskfree.
  6. Options & Futures

    How Low Can Oil Prices Go?

    Record low oil prices are a welcome development for consumers, but oil companies are struggling with choosing market share over profitability.
  7. Options & Futures

    SEC-Regulated Options Brokers

    Investopedia provides a List Of SEC-Regulated Options Brokers
  8. Options & Futures

    How To Trade Orange Juice Options

    How do orange juice options work and which factors determine the orange juice valuations? Here's a sneak peak into the world of orange juice options.
  9. Fundamental Analysis

    Explaining the Geometric Mean

    The average of a set of products, the calculation of which is commonly used to determine the performance results of an investment or portfolio.
  10. Options & Futures

    Why Is Best Buy Stock So Volatile?

    We look at why BBY has been so volatile in the past and whether this trend is likely to continue or abate in the future.

You May Also Like

Hot Definitions
  1. Yield Curve

    A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity ...
  2. Productivity

    An economic measure of output per unit of input. Inputs include labor and capital, while output is typically measured in ...
  3. Variance

    The spread between numbers in a data set, measuring Variance is calculated by taking the differences between each number ...
  4. Terminal Value - TV

    The value of a bond at maturity, or of an asset at a specified, future valuation date, taking into account factors such as ...
  5. Rule Of 70

    A way to estimate the number of years it takes for a certain variable to double. The rule of 70 states that in order to estimate ...
  6. Risk Premium

    The return in excess of the risk-free rate of return that an investment is expected to yield. An asset's risk premium is ...
Trading Center