Volatility Smile and Volatility Skew – Part 2: More Understanding

Go Back to Part 1: Description

What Do Volatility Smile and Volatility Skew Mean?
As you know, an option’s price comprises of Intrinsic Value and Time Value.
In options pricing, there are 6 factors that affect an option’s price: option’s strike price, underlying stock price, implied volatility, time to expiration, interest rate, and dividend.
An Intrinsic Value of an option is determined by the option’s strike price and the underlying stock price.
And the major determinant of option’s Time Value is Implied Volatility and time remaining to expiration.

Since Implied Volatility (IV) represents an estimate of future volatility, this factor is the most subjective. Therefore, Implied Volatility has been used by the market makers to “manipulate” the option’s price in order to balance the demand vs. supply of an option.
For instance, when the demand of a particular option is relatively higher than its supply, traders/investors will be willing to pay a “higher” price for that option. This high demand would in turn push the price of that option upwards (through increased IV), resulting in higher profit for the market makers from higher time value as a compensation for higher risks that they have to bear.

Hence, a Volatility Smile chart suggests that both ITM and OTM options are in higher demand (relative to their supply) than ATM options. Traders/investors are willing to pay a “higher” price to buy OTM and ITM options (through higher IV) than to buy ATM options.

It is important to note that “higher” price here does not mean higher in terms of dollar value.
ITM options will always be higher in terms of dollar value than ATM and OTM options, due to its Intrinsic Value.
However, OTM options could be “more expensive” than ATM and ITM in relation to their Implied Volatility.
In other words, the measure of an option’s expensiveness is its Implied Volatility.

As discussed earlier, the option is considered “expensive” when the IV is relatively high.
On the other hand, the option is considered cheap when the IV is relatively low.

Likewise, a Volatility Skew chart whereby IV values are higher for ITM options and then is declining as it moves towards OTM (i.e. for Call options), for instance, suggests that the demand for ITM options is relatively high and traders/investors are willing to pay a “higher” price to buy ITM options.

On the contrary, a Volatility Skew chart whereby IV values are higher for OTM options and then is decreasing as it moves towards ITM (i.e. for Put options) suggests that the demand for OTM options is relatively high and traders/investors are willing to pay a “higher” price to buy OTM options.

Continue to Part 3: Why Volatility Smile & Volatility Skew Happen

To understand more about Implied Volatility, go to: Understanding Implied Volatility (IV).

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