Volatility Smile

The volatility smile is a graphical representation of how implied volatility varies across different strike prices for options with the same expiration date. In a perfectly efficient market following standard models, implied volatility should be constant across all strikes.

However, empirical data shows that options with lower or higher strike prices often have higher implied volatility than at-the-money options, creating a U-shaped curve. This phenomenon occurs because market participants assign a higher probability to extreme price moves than what is predicted by a normal distribution.

In equity and crypto markets, this often manifests as a volatility skew, where out-of-the-money puts are more expensive due to demand for tail-risk hedging. The volatility smile provides insight into market expectations regarding the distribution of future asset prices.

It is a crucial tool for traders to understand the pricing of risk and the potential for black swan events. Analyzing the shape of the smile helps in identifying mispriced options.