Volatility Smiles

It is widely seen in currency trading and equity options. A Volatility smile is a graph that is obtained when a graph is drawn between the strike price and the corresponding volatility of a group of options having the same expiration date. The pattern will vary for different market. It won’t be same for all the markets. Volatility smile was seen in American market post market crash in 1987. It is widely used by quantitative analyst to determine the cost of options. The prices of the exotic options are calculated by the quantitative analyst using this volatility smile cure. They use the Vanilla option technique to determine the price of the options. In this method a primary assumption is made which says Price of option is strictly functions of volatility. According to this principle the Volatility can be used to determine the price and similarly the price can be used to determine the volatility.

Some of the factors responsible for the formation of Volatility smiles are broadly classified into two they are,

Behavioral cause

• Expectation of a crash in the market.

• Expectation of change in volatility in the market in the future over a period of time.

• Support or resistance levels at various strike price.

• Dealers tend to book zero-cost collar.

Structural cause

It happens when the Black Scholes assumptions are violated.

• During the inability of the investor to hedge the market.

• Jumps or during crash.

Volatility smile graph:

Question:

• What are the behavioral causes for Volatility smile?
• What are the advantages of Volatility smile?