Volatility smile is the visual depiction of implied volatility relative to an option’s strike price. The farther out-of-the-money an option is, the higher its implied volatility. Because of this skew, options increase on either side of the at-the-money strike price. Therefore, the implied volatility and strike price image resemble a smile.
Understanding Implied Volatility
Implied volatility (IV) measures the expected price movement for a security over a certain period. Options with higher implied volatility are typically more expensive. This phenomenon is known as the “volatility smile,” which shows how IV increases as you move away from at-the-money (ATM) options. By understanding the relationship between IV and option prices, traders can make better-informed decisions when buying or selling options.
It is important to note that implied volatility does not necessarily reflect actual market conditions; instead, it reflects investor sentiment about potential future events based on market participation. For example, if investors expect a large market move in either direction, they may be willing to pay higher premiums for out-of-the-money (OTM) calls or puts.
Using the Volatility Smile Curve
Traders and investors often use the volatility smile curve to help identify potential trades or investments. The shape of the volatility smile can provide insight into how certain options are priced and their implied volatilities relative to each other. By studying the shape of the curve, traders can gain insight into which option strikes may be more attractively priced than others.
The volatility smile helps traders identify when an option is overpriced or underpriced relative to other strike prices. If a particular strike price has a higher implied volatility than its historical average, it may indicate that it’s overpriced and could be sold for a profit. Conversely, if an option has an implied volatility lower than its historical average, it may be undervalued and could present an opportunity for purchase.
Finally, the shape of the volatility smile can also help traders identify potential arbitrage opportunities between different option strikes. For example, if one strike is trading at a significantly higher implied volatility than similar strikes on either side of it on the same expiration date, there could be an arbitrage opportunity where a trader buys one strike and sells another simultaneously to take advantage of any discrepancies in pricing.
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