The volatility smile is a visual representation of the implied volatilities of options contracts that expire on the same date. The appearance of a volatility smile indicates that options traders are willing to pay more for options that are in the money or out of the money than for options that are at the money, and that the further they are in or out of the money, the more traders will pay. It is a relatively rare occurrence that sometimes shows up during extreme market downturns. A financial advisor can explain whether and how options trades can be part of your investing strategy.
Volatility Smile Basics
A volatility smile is the name given to a particular pattern displaying the implied volatility of various options that all expire on the same date. When this pattern becomes turned up at the ends and U-shaped, which happens infrequently and usually during large drops in the market, options traders call it a volatility smile.
The volatility smile illustrates how the implied volatility of options may vary based on their intrinsic value. This intrinsic value is expressed as being in the money, out of the money or at the money. Whether an option is in, out of or at the money depends on the strike price, current trading price of the underlying asset and the type of option.
For example, a put option, which gives the buyer the right to sell an asset at a preset price on or before a certain date, is in the money when the underlying security is trading at a price below the strike price. It is at the money if the strike price is equal to the underlying asset’s price, and out of the money if the underlying asset is trading at a price above the strike price.
If a line showing the implied volatility of at-, in- and out-of-the money options were flat instead of U-shaped, it would mean all the options had the same implied volatility. Normally, at the money options have relatively low volatility. When a volatility smile appears, it suggests that traders look more favorably on writing call options than put options.
Using Volatility Smiles
In addition to volatility smiles, securities traders may use a number of visual patterns as aids to help them forecast the likely future behavior of markets. For instance, investors employing technical analysis may look for a pattern called a double bottom as an indicator that the price of a security is about to rise.
A volatility smile is not considered an indicator that the price of a security may be about to head in a specific direction. Instead, it is used to predict volatility, or the likelihood that a security’s price may move either up or down. While not necessarily directly related to price direction forecasts, volatility smiles can help traders evaluate the risk of a particular trade.
Volatility Smile Background
A volatility smile appeared for the first time during the 1987 Black Monday market crash. Its appearance is noteworthy, in part, because it may expose a flaw in the method many traders used to calculate the chances that an option will expire in the money.
The Black-Scholes model is a formula many traders use to guide their trades. The complex formula considers a number of factors, including current prices, dividends and interest rate trends as well as the strike price of the particular option and when it will expire.
The goal of the Black-Scholes model is to determine prices for options and other derivatives and it does this well enough that it has become the standard in the field since its introduction in the 1970s. The model does not predict the appearance of volatility smiles, however, suggesting that there may be a flaw in the formula. But it continues to be widely used by options traders.
A volatility smile is a visual display showing implied volatilities of options contracts forming a U-shaped pattern. It indicates that options that are either out of the money or in the money have higher implied volatility than options that are at the money. A volatility smile normally appears only during or after extreme market declines. One explanation for this unusual situation is that that traders see more volatility, either up or down, in the future and so there is more demand for options that are in or out of the money.
Tips for Investing
Consider talking to a financial advisor before investing in options or other derivatives. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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