Volatility Smile and Volatility Skew – Part 4: Implications

Go Back to Part 3: Why Volatility Smile and Skew Happen.

Implications of Volatility Smiles
In some cases, volatility charts of an option may shift over time from Volatility Skew to Volatility Smile, or vice versa.
When volatility charts of a particular stock’s options show a shift from Volatility Skew to Volatility Smile, this may signal an increased speculators’ interest into that stock, implying a possibility of volatile price movements for that stock due to certain reasons. (Please refer to Part 3 for more explanation).
For an options trader, this might offer some trading opportunities in order to take advantage of the potential volatile price movement. For instance, by buying straddle or strangle.

In addition, with the same logic, when an option of a stock displays Volatility Smiles, this stock is expected to be more volatile than a stock that displays a Volatility Skew pattern.
This might also provide some useful information/insight for the traders/investors in their investment decision.

Volatility Smiles and Time Remaining To Expiration
Volatility Smiles seem to be more likely to occur for options with shorter time to expiration.

When extreme price movements are expected to happen for a stock in the near term (which leads to huge interests in speculative trading for that stock), most speculators would more likely choose options with shorter time to expiration.
This makes sense as options with shorter time to expiration are lower in dollar term (as it carries less time value than longer-time-to-expiration options), and hence could potentially provide higher % returns when the extreme price movement does take place as expected.

Therefore, Volatility Smiles may particularly be observed in options nearing to expiration of a stock that is expecting big moves from pending news in the near term, due to heavy speculative trades during that period.

Calculating Estimated Option’s Price Using Options Calculator / Pricer
Since Implied Volatilities vary across different strike prices, it is therefore important to use the respective IV values for a particular strike price when we are calculating an estimated option’s price using options calculator / pricer (e.g. for calculating estimated options price for a stop or price target).
Otherwise, the accuracy of the estimated option’s price will be greatly affected.

Continue to Part 5: Strike Skew vs. Time Skew

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

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* Options Trading Basic – Part 1
* Options Trading Basic – Part 2
* Option Greeks
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