Volatility Smile In Options

Volatility Smile is a graph plotted between implied volatility and strike prices of Options belonging to same expiry. The graph resembles a person with a smiling face. Hence it’s termed as ‘Volatility Smile‘. Basically it is a geographical pattern of implied volatility for the series of the options. If plotted against the strike prices, then these implied volatility will make a line and the slopes upwards in either end, which is known as smile. Volatility smiles never occur based on the standard Black Scholes theory that normally assumes flat volatility curve. The cost of options can be more complicated rather than the cost of commodities or stocks and this will be well reflected in the volatility smile.

Volatility Smile

Reason for Volatility Smile

The most logical reason for the formation of volatility smile is the fact that traders are generally more inclined towards buying/selling in-the-money and out-of-the-money options as compared to at-the-money options. The more the demand, the more the volatility increases which is evident from Volatility smile graph. However, this theory does not hold true for all the option contracts, and you may not find perfect smile for all the options.

Volatility Smile to accomplish Delta Neutral Trades

Volatility smile can be used to trade Delta Neutral i.e. to profit irrespective of the movement of underlying stock. In attempting to capture the smile or skew, a trader can make the structure that is not having any outright delta and the effort to capture a premium is associated with a smile, which means that trade not having exposure in starting to downward or upward movements in underlying asset. A structure where traders can purchase one at-the-money put and selling two out-of-the-money puts are utilized to take benefits of the high relative skew on the out of the money options. This can also be accomplished on call side of the options structure vice versa. Selling strangle is also the way to advantage from a market, which can be created out-of-the-money options with the very huge smiles.

Does Volatility Smile leads to Market crash?

A perfect curvy volatility smile formation for any Option contracts is believed to indicate market crash in near future. The reason being rise in volatility for out the money put options hints heavy demand for Puts. Equity options traded in American markets did not show a volatility smile before the Crash of 1987 but began showing one afterwards. It is believed that investor reassessments of the probabilities of fat-tail have led to higher prices for out-the-money options. There is no solid theory that to support this argument till now.

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11 Comments

  1. Sir
    What is the meaning of buying put option at the money and selling out of the money put option.because if market is positive both option incurred loss and how delta will neutral as you mention in above volatility smile

    • Sir
      You mention in volatility smile such that buy one put at the money and sell two out the money put .kindly clarify sir

    • Hi Mala,

      Volatility smile can be utilized to accomplish Delta Neutral trades in two ways:

      1) Selling Strangle
      2) Buying one at-the-money put and selling two out-of-the-money puts

      • Sir
        Please advice me one example for delta neatral since in volatility smile chaptar mentioned that irrespective of market movement to make profit buy at the money put one lot and sell two lots in the money PUT same way I purchased when market is at 8233 that time I purchased on 12-12-2016 8200 PUT one lot and. 8150 call two lots instead of. Selling two lots put as per volality smile is it correct or wrong? Is wrong. In that time actually. What I would to do on 12-12-2016 kindly tell me sir please.

  2. Sir
    On 12-06-2016 according to option smile strgy I purchased 8200 at the money put option one lot and. Two lot call option of 8150 to make delta nuatral is this right strgy as per option smile please tell me sir since 8150 CE is now drastically come down

    • You position is not delta neutral. It has a net positive delta since you have bought 2 call options.

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