Volatility Smile

| December 8, 2011 | 0 Comments

Volatility smile is a fairly advanced options concept.  And while advanced, it’s not overly complicated…

The volatility smile is an observed pattern in which at-the-money (ATM) options tend to have lower implied volatilities than in- or out-of-the-money (OTM) options.  In essence, a volatility smile is a form of the options pricing concept volatility skew.

The volatility smile pattern results from the probability of extreme moves. For a better idea of the concept, take a look at the pattern below…

You can see that implied volatility is near its lowest point when the underlying is ATM strike price.  Volatility smiles tell us the demand is greater for options that are in-the-money or out-of-the-money.

So how is the volatility smile used?

Here’s the deal…

Volatility smile is an area of research actively used in quantitative finance.

For example, a quantitative analyst will first calculate the implied volatility of liquid vanilla (basic) options.  And then, they’ll use models of the volatility smile to calculate the price of more complex, or exotic options.

While an important tool when using exotic options, the volatility smile pattern won’t be required when trading options spreads, or many other options trading strategies.  For most options investors, the volatility smile patterns isn’t a tool you’ll need very often.

Category: Options Trading Basics

About the Author ()

Marcus Haber is the co-editor of Options Trading Research and boasts well over a decade of real-life options experience. Learning from some of the biggest names in the business, Marcus has served as an Options Strategist for a number of firms and was also appointed to the Options Advsiory Board with Pershing, a branch of the Bank of New York.