A:

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.

RELATED FAQS
  1. Implied Volatility

    Implied volatility is an important concept in option trading. Learn how it is calculated using the Black-Scholes option pricing ... Read Answer >>
  2. 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 >>
  3. Is volatility a good thing or a bad thing from the investor's point of view, and ...

    Learn the basics of volatility in the stock market and how the increased risk provides greater opportunities for profit for ... Read Answer >>
  4. 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 >>
Related Articles
  1. Trading

    Implied vs. Historical Volatility: The Main Differences

    Discover the differences between historical and implied volatility, and how the two metrics can determine whether options sellers or buyers have the advantage.
  2. Trading

    Ratio Writing: A High-Volatility Options Strategy

    Selling a greater number of options than you buy profits from a decline back to average levels of implied volatility.
  3. Trading

    Circumventing the Limitations of Black-Scholes

    Learn the ways to get around the flaws in trading models like Black-Scholes.
  4. Trading

    Factors That Determine Option Pricing

    Gain a thorough understanding of factors that affect price and how it is essential in options trading.
  5. Trading

    Sensitivity Analysis For Black-Scholes Pricing Model

    Trading options requires complex calculations, based on multiple parameters. Which factors impact option prices the most?
  6. Trading

    Why Volatility is Important For Investors

    Many investors realize the stock market is a volatile place to invest their money, learn how volatility affects investors and how to take advantage of it.
  7. Investing

    Nvidia's Shares At Risk Of Falling 12%

    Lofty Price: Nvidia's stock is entering a risky, volatile period for investors
  8. Investing

    A Guide to Understanding Market Volatility

    Market volatility is inevitable. Understanding how it works can help investors keep calm during periods of short-term declines.
  9. Investing

    Oil Volatility and How to Profit From It

    The recent volatility in oil prices presents an excellent opportunity for traders to make a profit if they are able to predict the right direction.
RELATED TERMS
  1. Volatility Smile

    A volatility smile is a u-shaped pattern that develops when an ...
  2. Implied Volatility - IV

    The estimated volatility of a security's price derived from an ...
  3. Dialing and Smiling

    Dialing and smiling is a telemarketing technique in which unsolicited ...
  4. Volatility Arbitrage

    Volatility arbitrage is a trading strategy that attempts to profit ...
  5. Option Premium

    An option premium is the income received by an investor who sells ...
  6. Heston Model

    The Heston Model is a type of stochastic volatility model used ...
Trading Center