The volatility smile is a long observed chart pattern in which at-the-money (ATM) options have lower implied volatility than in-the-money (ITM) or out-of-the-money options (OTM). The pattern displays different characteristics for different markets and shows the probability of extreme moves.
Using the Black Scholes pricing model, you can compute the volatility of the underlying market by inputting the market prices for the options. In theory, for options with the same expiration date, you’d expect the implied volatility to be the same regardless of which strike price was used. However, in reality, the implied volatility you get is different across the various strike prices. This disparity is known as the volatility skew.
If you plot the implied volatility against the strike price, you would get the following U-shaped curve pattern resembling a smile. Hence the name volatility smile.
Volatility smiles tell us that demand is greater for options that are either in-the-money (ITM) or out-of-the-money (OTM).
Volatility Skew (Smirk)
When you can’t quite manage a smile a smirk will have to do. The volatility smirk (sometimes called volatility skew) is a more common pattern which typically appears for longer term equity and index options.
A volatility skew (smirk) can have either a forward or reverse bias; let’s have a look at them both in more detail.
The reverse skew implies volatility for options at the lower strike price is higher than the implied volatility at the higher strike price. Therefore the reverse screw suggests that in-the-money (ITM) calls and out-of-the-money (OTM) puts are more expensive compared to out-of-the-money (OTM) calls and in-the-money (ITM) puts.
The most popular explanation for the manifestation of reverse skews 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 (ITM) 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 implied volatility at the lower strikes.
The other variant of the volatility skew (smirk) is the forward skew. In the forward skew pattern, the implied volatility for options at a lower strike price is lower than the implied volatility at a higher strike price. This suggests that out-of-the-money (OTM) calls and in-the-money (ITM) puts are in greater demand compared to in-the-money (ITM) calls and out-of-the-money (OTM) puts.
The forward skew pattern is common for options in the commodities market. When supply is tight, traders would rather pay more to secure supply than to risk disruption. For example, if weather reports indicate a heightened possibility of frost, fear of supply disruption will cause traders to drive up demand for out-of-the-money calls for the affected crops like wheat and barley.
The volatility smile is a useful tool for monitoring market volatility. It can help you decide whether to buy in-the-money or out-of-the-money calls or puts.
One of the most popular strategies using this indicator is monitoring individual stocks and waiting for the volatility skew, forward or reverse, to turn into a full smile. This indicates that speculators are pouring into the stock and you should be prepared for an extreme move.
This is a fairly advanced strategy that requires constant monitoring of the market, so it’s not particularly suitable for beginners. But it’s always a good idea to monitor your charts and look for these patterns forming. That way you’ll better understand them when you’re ready to trade them.
Not all options brokers offer the tools required to build volatility charts, there’s not a lot you can do about that unless you change broker. If you’re looking for a new broker, optionsXpress have an excellent tool-set that enables you to build volatility charts and much more, so I’d recommend you give them a try.