Volatility Smile
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In Finance, Volatility Smile refers to the long-observed pattern in which at-the-money options tend to have lower implied volatilities than other options. The pattern displays different characteristics for different markets, and is an area of significant academic research (i.e., it is not well understood).
A closely related concept is that of Term Structure of Volatility, which refers to how implied volatility differs for related options with different maturities. An Implied Volatility Surface is a 3-D plot that combines Volatility Smile and Term Structure of Volatility into a consolidated view of all options for an underlier.
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[edit] Volatility smiles and implied volatility
There is a one-to-one correspondence between the value of any financial derivative contract, such as an option, and the Volatility of its underlying asset. In general, the more volatile the asset, the more the derivative contract is worth. Thus, when a market has set the price for a contract, it is often the case that this price entails a unique Implied volatility.
When implied volatility is plotted against increasing strike price, the resulting graph is typically downward sloping, or downward sloping with an upward bend at either end. For markets where the graph is downward sloping, such as for equity options, the term Volatility Skew is often used. For other markets, such as FX options or equity index options, where the typical graph turns up at either end, the more familiar term Volatility Smile is used. For example, the implied volatility for downside (i.e. low strike) equity options is typically higher than for upside equity options. However, the implied volatilities of options on foreign exchange contracts tend to rise in both the downside and upside directions. (hence the term ‘Volatility Smile’).
In the case of equity options, the higher implied volatilities for downside options represent the market's expectation that realized volatilities will increase if the stock price were to fall. Similarly, the lower implied volatilities for upside options indicates that the market anticipates lower realized volatilities if stock prices go up. In other words, the market is rationally forecasting that a stock that loses value rapidly will in fact become more volatile, possibly because the likelihood of financial distress has increased. Likewise, a stock that rises in value is predicted to become less volatile as its financial situation improves.
[edit] Implied volatility and historical volatility
It is helpful to note that implied volatility is related to historical volatility, however the two are distinct. Historical volatility is a direct measure of the movement of the underlier’s price (realized volatility) over recent history (e.g. a trailing 21-day period). Implied volatility, in contrast, is set by the market price of the derivative contract itself, and not the underlier. Therefore, different derivative contracts on the same underlier have different implied volatilities. For instance, the IBM call option, struck at $100 and expiring in 6 months, may have an implied volatility of 18%, while the put option struck at $105 and expiring in 1 month may have an implied volatility of 21%. At the same time, the historical volatility for IBM for the previous 21 day period might be 17% (all volatilities are expressed in annualized percentage moves).
[edit] Term Structure of Volatility
For options of different maturities, we also see characteristic differences in implied volatility. However, in this case, the dominant effect is related to the market's implied impact of upcoming events. For instance, it is well-observed that realized volatility for stock prices rises significantly on the day that a company reports its earnings. Correspondingly, we see that implied volatility for options will rise during the period prior to the earnings announcement, and then fall again as soon as the stock price absorbs the new information. Options that mature earlier exhibit a larger swing in implied volatility than options with longer maturities. Again, this seems perfectly rational, given that the market is pricing into the options' implied volatility its best estimate of the impact of future events.
Other option markets show other behavior. For instance, options on commodity futures typically show increased implied volatility just prior to the announcement of harvest forecasts. Options on US Treasury Bill futures show increased implied volatility just prior to meetings of the Federal Reserve Board (when changes in short-term interest rates are announced).
The market incorporates many other types of events into the term structure of volatility. For instance, the impact of upcoming results of a drug trial can cause implied volatility swings for pharmaceutical stocks. The anticipated resolution date of patent litigation can impact technology stocks, etc.
[edit] Implied Volatility Surface
It is often useful to plot implied volatility as a function of both strike price and time to maturity. The result is a 3-D surface whereby the current market implied volatility (Z-axis) for all options on the underlier is plotted against strike price and time to maturity (X & Y-axes).
The implied volatility surface simultaneously shows both Volatility Smile as well as Term Structure of Volatility. Option traders use an implied volatility plot to quickly determine the shape the implied volatility surface, and to identify any areas where the slope of the plot (and therefore relative implied volatilities) seems out of line.
The graph shows an implied volatility surface for all the call options on a particular underlying stock price. The Z-axis represents implied volatility in percent, and X and Y axes represent the option delta, and the days to maturity. Note that to maintain Put-call parity, a 20 delta put must have the same implied volatility as an 80 delta call. For this surface, we can see that the underlying symbol has both volatility skew (a tilt along the delta axis), as well as a volatility term structure indicating an anticipated event in the near future.
[edit] External links
- Emanuel Derman, The Volatility Smile and Its Implied Tree (RISK, 7-2 Feb.1994, pp. 139-145, pp. 32-39) (PDF)
- Mark Rubinstein, Implied Binomial Trees (PDF)
- Econophysics Blog: The Sardonic Smirk: The Volatility Smile and the Asymmetry of Risk
- OptionsToolbox: Chart volatility skew for optionable stocks
[edit] See Also
- Jim Gatheral
- Steven Heston
- Emmanuel Derman
- Nassim Nicholas Taleb
