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 BlackScholes 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 wellreflected 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 inthemoney or outofthemoney as opposed to atthemoney options. Others suggest that betterdeveloped options models have led to outofthemoney 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 BlackScholes model, particularly with the valuation of downside puts that are far away from the money.

How does implied volatility impact the pricing of options?
Learn about two specific volatility types associated with options and how implied volatility can impact the pricing of options. Read Answer >> 
Implied Volatility
Implied volatility is an important concept in option trading. Learn how it is calculated using the BlackScholes option pricing ... Read Answer >> 
What is the relationship between implied volatility and the volatility skew?
Learn what the relationship is between implied volatility and the volatility skew, and see how implied volatility impacts ... Read Answer >> 
If the stock market is so volatile, why would I put money into it?
Learn how the up and down movement of price, known as volatility, can benefit shortterm investors and why longterm investors ... Read Answer >> 
Which market indicators reflect volatility in the stock market?
Learn the most commonly used technical indicators of stock market volatility that are watched by stock market traders and ... Read Answer >>

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