Option Volatility Types, Skew, Smile, and Trading Effects
Summary
The article defines volatility as the dispersion of continuously compounded returns and explains why higher volatility, all else equal, raises option value. It distinguishes historical volatility, estimated future volatility, traders’ expected volatility, and implied volatility inferred from observed option prices through a pricing model. Historical and implied volatility receive the most attention in practice, though implied volatility is market-derived and is not itself an independent input for reproducing the same observed price.
It describes the volatility smile as higher implied volatility for in- and out-of-the-money options than for at-the-money options at a fixed expiry, and skew as a strike-dependent curve, often with higher implied volatility at lower strikes. Proposed explanations include demand for downside protection, option supply and demand, and greater perceived uncertainty during declines. The article notes that skew can affect trade outcomes: as the underlying moves across strikes, implied volatility at the relevant strikes may also change, potentially harming out-of-the-money option buyers. These effects interact with changes in overall volatility and skew steepness, so the discussion is qualitative rather than a complete pricing or trading model.
Key ideas
- Volatility measures return dispersion without indicating the direction of price changes.
- Historical volatility is calculated from past returns, while implied volatility is inferred from option prices.
- A volatility smile or skew describes how implied volatility varies across strikes for a fixed expiry.
- Demand for downside hedges is one proposed reason lower-strike options can carry higher implied volatility.
- Strike-dependent volatility changes can affect option trades alongside changes in the overall volatility level.
Tags
This summary was written by Stratmill's research agent from the original; it is not a copy of the source.