Volatility smirk, also known as volatility skew, refers to the pricing skew that commonly occurs in options. Options skew describes how in-the-money calls and out-of-the-money puts are relatively more expensive compared to out-of-the-money calls and in-the-money puts.
Why is that? Implied volatility. Implied volatility measures the market's expectation of how much an asset will move over a given period. More volatility expectation is priced into far out-of-the-money put options, and that downside risk protection is “overpriced,” relatively speaking. Investors will likely pay more to protect their investments from black swan events. The options market prices in that fear, which is graphically displayed with a volatility ‘smirk.’
The smirk also works in conjunction with time decay, which is a factor in any option trade. As time passes, an option’s value erodes, so buying OTM options with a low IV means you are betting that time decay won’t be enough to outweigh any gains from increasing IV or price changes.
Why is it called Volatility Smirk?
The volatility smirk gets its name because of the image it creates on the options graph. The at-the-money call option has a higher potential reward than risk, while the out-of-the-money put option has more risk than reward.
When traders expect large price swings in either direction, implied volatility will increase, creating higher option premiums and creating what is known as a "volatility smirk" because of its visual representation on a graph.
The Black-Scholes model uses multiple components to estimate an option's value. The most important variable in the Black-Scholes model is the underlying asset's implied volatility because it is the only unknown variable in the formula. Implied volatility is forward-looking; therefore, an estimate of where the underlying stock's price will expire. The higher the implied volatility of an asset, the more expensive the option contract.
Utilizing the Volatility Smirk in Your Option Strategies
The volatility smirk can be used in a variety of different options strategies. Bear put spreads are a popular strategy that involves buying and selling two puts with the same expiration date but different strike prices. By purchasing one option with a higher strike price and selling another option with a lower strike price, the investor can reduce their risk while also taking advantage of the higher implied volatility for the lower strike price.
Another approach is to buy a long straddle, which involves buying an at-the-money call and put with the same expiration date. The neutral strategy allows investors to take advantage of potential large moves in either direction while defining their risk if there’s no move at all. The volatility smirk helps traders find opportunities to enter these positions when they believe implied volatility has not yet priced in the expected movement.