Educational Reading Links

Good readings for trading education:

Van K. Tharp in IITM.com: Understanding Market Type

Libby Adams in IITM.com: YOU are the Holy Grail

Afraid To Trade: Revisiting Stop-Loss and Profit Target Affect on Win Rate

The Stock Bandit: Patient Progress

Swing Trade Stocks: How to Get More Winners by Combining Chart Patterns

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Volatility Smile and Volatility Skew – Part 3: Why Volatility Smile and Skew Happen

Go Back to Part 2: Understanding Volatility Smile & Volatility Skew

Why Do Volatility Smile & Volatility Skew Happen?

As mentioned in Part 1, in more recent years, Volatility Skew pattern are more commonly observed than Volatility Smile pattern.

For Call options, the Implied Volatility (IV) typically displays a Volatility Skew pattern, whereby IV is the highest for deep ITM options and then is decreasing as it moves towards OTM options.

As discussed earlier, traders/investors are willing to buy an “expensive” deep ITM Calls because they can be used as a leverage tool to gain higher % return with lower capital, as compared to invest in the stock itself. Since deep ITM Calls have delta close to 1, they works like stocks, moving almost dollar for dollar with the stock price, but with much lower capital.
In addition, when extreme price movements are expected, this may also mean that stocks can move sharply to the opposite direction. When the stock prices do not move as expected, ITM options would have lower risk of losing all the money than would ATM and OTM options, due to their inherent intrinsic value.

In contrast, for Put options, the IVs also display a Volatility Skew pattern, whereby IV is the highest for deep OTM options and then is decreasing as it moves towards ITM options.
As mentioned previously, the possible reason why people are willing to buy an “expensive” deep OTM Puts are that probably they are viewed as a form of “insurance” against market crash.
In addition, deep OTM Puts are also considered low cost in terms of dollar; hence this might offer another reason why the deep OTM Puts are quite widely used as an insurance / protection tool of one’s portfolio.


Although Volatility Skew is the typical volatility pattern observed most of the time, sometimes Volatility Smile may appear due to some reasons. And the appearance of Volatility Smile might carry some signals to the market.

Volatility Smiles might indicate that the market is expecting a high possibility of extreme stock price movements as result of either increased volatility in the overall market or in a particular stock.
This might arise in anticipation of corporate news announcements or any pending news that will potentially result in a volatile movement in the stock price.

When big movement in stock price is highly possible, OTM options are more likely to become the ITM options. When this really happens, OTM options will produce higher % return than ATM and ITM would. Moreover, OTM options are lower in terms of dollar. This kind of situations may attract speculators to rush and bet into the market by buying OTM options in order to take advantage of the potential extreme movement in stock price.

Under these circumstances, the speculators would be willing to pay a “higher” price for OTM options as well. This would then drive the price of OTM options upwards through increased IV.
As a result, when plotted into the chart, the IV would show a Volatility Smile pattern, whereby the IVs of both ITM and OTM options are higher (more “expensive”) than the IV of ATM options.

Continue to Part 4: Implications of Volatility Smile & Volatility Skew

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

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* FREE Trading Educational Resources You Should Not Miss
* Option Greeks
* Learning Candlestick Charts
* Learning Charts Patterns
* Getting Started Trading

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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).

Related Topics:
* Learn from Famous Trading Gurus for FREE
* Option Price Components
* OPTION PRICING: How Is Option Priced?
* Options Trading Basic – Part 1
* Options Trading Basic – Part 2
* Option Greeks

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Volatility Smile and Volatility Skew – Part 1: Description

Previously, we’ve talked a bit about Volatility Smile and Volatility Skew in this article.

Basically, Volatility Smile and Volatility Skew show that even for the same expiration month, Implied Volatilities (IVs) can vary by strike price.
We can get Volatility Smile or Volatility Skew charts by plotting the IV values of options for the same expiration month across various strike prices.

For some options, given the same expiration month, the IVs of In-The-Money (ITM) & Out-of-The-Money (OTM) options are higher At-The-Money (ATM) options.
As a result, when the IVs for various strike prices are plotted into a chart, it would take shape approximately like a U-pattern, which is by glance, it looks like a smile.
As such, this kind of chart is often known as “Volatility Smile”.

Some options may have higher IV for more ITM options, and then is decreasing as it moves towards OTM options.
On the other hand, other options might have higher IV for more OTM options, and then is declining as it goes towards ITM options. Such patterns are often called “Volatility Skew”.



In one paper on “Volatility Smile”, Don Chance suggested that the relationship between Implied Volatility and Option’s Strike Price has been documented since at the least the 1987 market crash.

When first observed, the relationship between the two variables took shape as a Volatility Smile. However, in more recent years, the Volatility Smiles have mostly disappeared, and Volatility Skews are more commonly observed.

The typical volatility patterns observed recently are as follow:

For Call options, the Implied Volatility is typically the highest for deep ITM options and then is decreasing as it moves towards OTM options.

For Put options, the Implied Volatility is typically the highest for deep OTM options and then is decreasing as it moves towards ITM options.

In other words, generally the “most expensive” options are deep ITM Calls and deep OTM Puts.

As to the reasons why certain options are “more expensive” than the others, Don Chance said that actually no one really knows.

For Put options, the possible reason why people are willing to buy an “expensive” deep OTM Puts are that they are viewed as a form of “insurance” against market crash. The lower cost in terms of dollar might also offer another reason for deep OTM Puts to serve as an insurance / protection tool of one’s portfolio.

For Call options, the possible reason why traders/investors are willing to buy an “expensive” deep ITM Calls are that they can be used as a leverage tool to gain higher % return with lower capital rather than to invest in the stock itself. Because deep ITM Calls have delta close to 1 and hence it works like stocks, moving almost dollar for dollar with the stock price, but with much lower capital.

Continue to Part 2: More Understanding of Volatility Smile & Volatility Skew

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

Related Topics:
* FREE Trading Educational Resources You Should Not Miss
* Options Trading Basic – Part 1
* Options Trading Basic – Part 2
* Option Greeks
* Learning Candlestick Charts
* Learning Charts Patterns

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Good Reading Links

Good readings for trading education:

Vix & More: What Is High Implied Volatility?

The Stock Bandit: Stop Loss Discussion

The Stock Bandit: Trading Video - Tips on Trading Breakouts

Ray Baros: Thinking ‘Three Moves Ahead’ IV

Read More