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.
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 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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