A Volatility smile (https://www.investopedia.com/terms/v/volatilitysmile.asp) is a U or smile shaped curve obtained when implied volatility is plotted against different strike prices options with the same expiration date.
According to the famous Black-Scholes model, implied volatility would be the same for all the options that expire on the same date regardless of the strike price. Therefore, implied volatility curve should be flat when plotted against the strike price. But in real practice, implied volatility is higher as the options go in-the-money and out-of-the-money, forming a curve in the shape of a smile. This shape of the curve suggests that demand for in-the-money and out-of-the money options is more than the demand of at-the-money options and therefore large moves may erupt soon.
Typically, out of the money options have slightly higher volatilities than at the money options. But sometimes the “smile” is “skewed”, i.e. equally out of the money calls and puts differ in their Implied volatility.
In the 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
The skew thus represents the market’s bias towards calls or puts and can result in sharp movements on one side.
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.
A perfect curvy volatility smile formation for any Option contracts is believed to indicate a 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.
How to use volatility skew as an indicator?
When the skew ratio is greater than one (>1.00), it shows trader sentiment is bullish, when the ratio is less than one (<1.00), it shows trader sentiment is bearish toward a stock.
There are three useful pieces of information that one can infer from an underlying’s volatility skew:
1. The direction in which the risk is perceived to be in the underlying.
2. How implied volatility will change relative to movements in the underlying.
3. The prices of the call spread and put spreads on that underlying.
Books Recommended: The Volatility Smile : Emanuel Derman and Michael B. Miller (see video at https://www.bloomberg.com/news/videos/2016-09-23/the-lasting-impact-of-the-1987-stock-market-crash)
Want to know what could possibly be leading to a major move in the US markets soon ? Read more at https://www.businessinsider.in/The-choppy-trading-thats-rocking-stocks-is-an-ominous-sign-for-the-future-of-the-bull-market-says-Bank-of-America/articleshow/63513643.cms