Volatility Smiles & Smirks Explained

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Contents

Volatility Smiles & Smirks

Volatility Skew Definition:
Using the Black Scholes option pricing model, we can compute the volatility of the underlying by plugging in the market prices for the options. Theoretically, for options with the same expiration date, we expect the implied volatility to be the same regardless of which strike price we use. However, in reality, the IV we get is different across the various strikes. This disparity is known as the volatility skew.

Volatility Smile

If you plot the implied volatilities (IV) against the strike prices, you might get the following U-shaped curve resembling a smile. Hence, this particular volatility skew pattern is better known as the volatility smile.

The volatility smile skew pattern is commonly seen in near-term equity options and options in the forex market.

Volatility smiles tell us that demand is greater for options that are in-the-money or out-of-the-money.

Reverse Skew (Volatility Smirk)

A more common skew pattern is the reverse skew or volatility smirk. The reverse skew pattern typically appears for longer term equity options and index options.

In the reverse skew pattern, the IV for options at the lower strikes are higher than the IV at higher strikes. The reverse skew pattern suggests that in-the-money calls and out-of-the-money puts are more expensive compared to out-of-the-money calls and in-the-money puts.

The popular explanation for the manifestation of the reverse volatility skew is that investors are generally worried about market crashes and buy puts for protection. One piece of evidence supporting this argument is the fact that the reverse skew did not show up for equity options until after the Crash of 1987.

Another possible explanation is that in-the-money calls have become popular alternatives to outright stock purchases as they offer leverage and hence increased ROI. This leads to greater demands for in-the-money calls and therefore increased IV at the lower strikes.

Forward Skew

The other variant of the volatility smirk is the forward skew. In the forward skew pattern, the IV for options at the lower strikes are lower than the IV at higher strikes. This suggests that out-of-the-money calls and in-the-money puts are in greater demand compared to in-the-money calls and out-of-the-money puts.

The forward skew pattern is common for options in the commodities market. When supply is tight, businesses would rather pay more to secure supply than to risk supply disruption. For example, if weather reports indicates a heightened possibility of an impending frost, fear of supply disruption will cause businesses to drive up demand for out-of-the-money calls for the affected crops.

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Buying Straddles into Earnings

Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

Best Binary Options Brokers 2020:
  • Binarium
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    1st Place! Best Binary Broker 2020!
    Best Choice for Beginners — Free Education + Free Demo Acc!
    Sign-up and Get Big Bonus:

  • Binomo
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    2nd place! Good choice!

Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

What are Binary Options and How to Trade Them?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]

Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

Volatility Smile Definition and Uses

What Is a Volatility Smile?

A volatility smile is a common graph shape that results from plotting the strike price and implied volatility of a group of options with the same underlying asset and expiration date. The volatility smile is so named because it looks like a smiling mouth. Implied volatility rises when the underlying asset of an option is further out of the money (OTM) or in the money (ITM), compared to at the money (ATM). The volatility smile does not apply to all options.

Key Takeaways

  • When options with the same expiration date and the same underlying asset, but different strike prices, are graphed for implied volatility the tendency is for that graph to show a smile.
  • The smile shows that the options that are furthest in- or out-of-the-money have the highest implied volatility.
  • Options with the lowest implied volatility have strike prices at- or near-the-money.
  • Not all options will have an implied volatility smile. Near-term equity options and currency-related options are more likely to have a volatility smile.
  • A single option’s implied volatility may also follow the volatility smile as it moves more ITM or OTM.
  • While implied volatility is one factor in options pricing, it is not the only factor. A trader must be aware of what other factors are driving an option’s price and its volatility.

What Does a Volatility Smile Tell You?

Volatility smiles are created by implied volatility changing as the underlying asset moves more ITM or OTM. The more an option is ITM or OTM, the greater its implied volatility becomes. Implied volatility tends to be lowest with ATM options.

The volatility smile is not predicted by the Black-Scholes model, which is one of the main formulas used to price options and other derivatives. The Black-Scholes model predicts that the implied volatility curve is flat when plotted against varying strike prices. Based on the model, it would be expected that the implied volatility would be the same for all options expiring on the same date with the same underlying asset regardless of the strike price. Yet, in the real-world, this is not the case.

Volatility smiles started occurring in option pricing after the 1987 stock market crash. They were not present in U.S. markets prior, indicating a market structure more in line with what the Black-Scholes model predicts. After 1987, traders realized that extreme events could happen and markets have a significant skew. The possibility for extreme events needed to be factored into options pricing. Therefore, in the real world, implied volatility increases or decreases as options move more ITM or OTM.

Also, the volatility smile’s existence shows that OTM and ITM options tend to be more in demand than ATM options. Demand drives prices which affects implied volatility. This could be partially due to the reason mentioned above. Extreme events can occur causing significant price shifts in options. The potential for large shifts is factored into implied volatility.

Example of How to Use the Volatility Smile

Volatility smiles can be seen when comparing various options with the same underlying asset and same expiration date, but different strike prices. If the implied volatility is plotted for each of the different strike prices, there may be a u-shape. The u-shape is not always perfectly formed as depicted in the graph.

For a rough estimate of whether an option has a u-shape, pull up an options chain that lists the implied volatility of the various strike prices. If the option has a u-shape, options that are ITM and OTM by an equal amount should have roughly the same implied volatility. The further ITM or OTM the greater the implied volatility, with the lowest implied volatilities near the ATM options. If this is not the case, the option does not align with a volatility smile.

The implied volatility of a single option could also be plotted over time relative to the price of the underlying asset. As the price moves into or out of the money, the implied volatility may take on some form of a u-shape.

This can be useful if seeking an option that has lower implied volatility. In this case, choose an option near the money. If looking for greater implied volatility, choose an option that is further ITM or OTM. Remember, though, as the underlying moves closer or further away from the strike price this will affect the implied volatility. Therefore, maintaining a portfolio of options with a specific implied volatility will require continual reshuffling.

Not all options align with the volatility smile. Before using the volatility smile to aid in making trading decisions, check to make sure the option’s implied volatility actually follows the smile model.

The Difference Between a Volatility Smile and a Volatility Skew/Smirk

While near-term equity options and forex options lean more toward aligning with a volatility smile, index options and Long-term equity options tend to align more with a volatility skew. The skew/smirk shows that implied volatility may be higher for either ITM or OTM options.

Limitations of Using the Volatility Smile

First, it is important to determine if the option being traded actually aligns with a volatility smile. The volatility smile is one model that an option may align with, but implied volatility could align more with a reverse or forward skew/smirk.

Also, due to other market factors, such as supply and demand, the volatility smile (if applicable) may not be a clean u-shape (or smirk). It may have a basic u-shape, but could be choppy with certain options showing more or less implied volatility than would be expected based on the model.

The volatility smile highlights where traders should look if they want more or less implied volatility, yet there are many other factors to consider when making an options trading decision.

Volatility Smiles & Smirks

Definition:
A put option is an option contract in which the holder (buyer) has the right (but not the obligation) to sell a specified quantity of a security at a specified price (strike price) within a fixed period of time (until its expiration).

For the writer (seller) of a put option, it represents an obligation to buy the underlying security at the strike price if the option is exercised. The put option writer is paid a premium for taking on the risk associated with the obligation.

For stock options, each contract covers 100 shares.

Buying Put Options

Put buying is the simplest way to trade put options. When the options trader is bearish on particular security, he can purchase put options to profit from a slide in asset price. The price of the asset must move significantly below the strike price of the put options before the option expiration date for this strategy to be profitable.

A Simplified Example

Suppose the stock of XYZ company is trading at $40. A put option contract with a strike price of $40 expiring in a month’s time is being priced at $2. You strongly believe that XYZ stock will drop sharply in the coming weeks after their earnings report. So you paid $200 to purchase a single $40 XYZ put option covering 100 shares.

Say you were spot on and the price of XYZ stock plunges to $30 after the company reported weak earnings and lowered its earnings guidance for the next quarter. With this crash in the underlying stock price, your put buying strategy will result in a profit of $800.

Let’s take a look at how we obtain this figure.

If you were to exercise your put option after earnings, you invoke your right to sell 100 shares of XYZ stock at $40 each. Although you don’t own any share of XYZ company at this time, you can easily go to the open market to buy 100 shares at only $30 a share and sell them immediately for $40 per share. This gives you a profit of $10 per share. Since each put option contract covers 100 shares, the total amount you will receive from the exercise is $1000. As you had paid $200 to purchase this put option, your net profit for the entire trade is $800.

This strategy of trading put option is known as the long put strategy. See our long put strategy article for a more detailed explanation as well as formulae for calculating maximum profit, maximum loss and breakeven points.

Protective Puts

Investors also buy put options when they wish to protect an existing long stock position. Put options employed in this manner are also known as protective puts. Entire portfolio of stocks can also be protected using index puts.

Selling Put Options

Instead of purchasing put options, one can also sell (write) them for a profit. Put option writers, also known as sellers, sell put options with the hope that they expire worthless so that they can pocket the premiums. Selling puts, or put writing, involves more risk but can be profitable if done properly.

Covered Puts

The written put option is covered if the put option writer is also short the obligated quantity of the underlying security. The covered put writing strategy is employed when the investor is bearish on the underlying.

Naked Puts

The short put is naked if the put option writer did not short the obligated quantity of the underlying security when the put option is sold. The naked put writing strategy is used when the investor is bullish on the underlying.

For the patient investor who is bullish on a particular company for the long haul, writing naked puts can also be a great strategy to acquire stocks at a discount.

Put Spreads

A put spread is an options strategy in which equal number of put option contracts are bought and sold simultaneously on the same underlying security but with different strike prices and/or expiration dates. Put spreads limit the option trader’s maximum loss at the expense of capping his potential profit at the same time.

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Continue Reading.

Buying Straddles into Earnings

Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

What are Binary Options and How to Trade Them?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]

Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

Best Binary Options Brokers 2020:
  • Binarium
    Binarium

    1st Place! Best Binary Broker 2020!
    Best Choice for Beginners — Free Education + Free Demo Acc!
    Sign-up and Get Big Bonus:

  • Binomo
    Binomo

    2nd place! Good choice!

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