Earlier, we learned the concept of implied volatility which is an estimate of future volatility. Now in this chapter, we will study a pattern of implied volatility (IV) known as 'Volatility Smile.'
Volatility smiles are IV patterns that develop while pricing options. When the IV of options (with the same expiration date, underlying asset, but different strike prices) is plotted, the graph has a tendency to show a smile.
Changes in volatility for options:
Volatility smile shows the more the option is in ITM or OTM, the greater the IV becomes. IV tends to be lowest for ATM options.
This smile is known as Volatility Skew. It is interesting that this pattern has existed only since the stock market crash of 1987. Prior to October 1987, implied volatilities were not much dependent on strike prices. This led to a conclusion that one reason for the equity volatility skew may be ‘crashophobia’. Since then traders are concerned about the possibility of a similar crash, they price the options accordingly.
'Volatility smile' is generally observed in near term equity options and forex options. However, index options and long term equity options tend to have a volatility skew.