by Amanda Harvey
The volatility smile is the charted representation of the relationship between implied volatility, which is a method of predicting how much fluctuation the price of a security is likely to undergo, and the strike price of an option based on the same underlying asset with the same expiration date. When this pattern is in evidence, as the market price moves further in either direction from the strike price, meaning that the option is becoming increasingly either in-the-money, or out-of-the-money, the implied volatility also increases. These upward curves in both directions from a low point in the center provide the visual impression of a smiling mouth, hence the name ‘volatility smile.’
The volatility smile indicates that an option is likely to experience more fluctuation in price as it moves away from the center point of the smile, which is when its strike price is equal to the current market price of the underlying stock.
This middle point where the implied volatility is relatively low is when the strike price of the option is ‘at the money.’ If a trader was to exercise the option at this point, they would not stand to make a profit as they would simply be buying the stocks that their options contract entitles them to buy at the same cost as if they were buying the shares at market price without an options contract. There tends to be a decrease in the volume of trading when options are at- or near- the money, as this time generally offers less potential for profit through application of directional trading strategies. The reduced demand goes hand in hand with the lower implied volatility that these options display on the volatility smile.
It is interesting to note that the volatility smile theoretically should not exist according to the Black Scholes options pricing model. The Black Scholes Model assumes a constant level of implied volatility, which appeared to be a fairly correct assumption prior to 1987, which is the first time that a recognizable volatility smile was recognized in the history of the US stock market.
Some general thoughts regarding this inconsistency infer that the stock market’s patterns of volatility have changed over time. Before the stock market crash of 1987, the overall behavior of market volatility appeared to be more in keeping with the suppositions of the Black Scholes Theory. The reasons for the development of conditions which produce the volatility smile pattern may include the fear of further dramatic market downturns leading to the increased volatility of out-of-the-money options, while the rise with in-the-money options may be attributed more to the greater demand for these options.
One point of particular relevance about higher implied volatility is that this is directly correlated with the pricing of options as high volatility generally translates to higher priced options. The volatility smile may provide an indication that there is greater demand for options which are further away from the mid-point of being at-the-money. With increased volatility there is a greater possibility of achieving the price movement desired by a trader during the life of the options contract.
There are various trading strategies that can be applied to take advantage of the logistics indicated by the volatility smile. Higher volatility can make credit options strategies or covered calls extremely profitable as there is much more extrinsic value from which to profit.
Whatever a trader’s style and strategy, it is worthwhile to be aware of the implications and opportunities presented by the volatility smile, as volatility is such an integral aspect of successful options trading.