A volatility smirk, a variation of the more common volatility smile, is depicted by plotting the strike price and implied volatility of options for a specific underlying asset, such as a stock, all sharing the same expiration date.
In a volatility smirk, the implied volatility (IV) of options on a given underlying security or index decreases as options move further in-the-money (ITM) or out-of-the-money (OTM). This results in a graphical representation that slopes downward, resembling a smirk.
This differs from a volatility smile, which exhibits a U-shaped curve with higher IV for both deep in-the-money (ITM) and OTM options compared to at-the-money (ATM) options. In contrast, a volatility smirk’s downward slant indicates that as options become deeply ITM or OTM, their implied volatility decreases.
Implications of a Volatility Smirk
- Market Expectations
Directional Bias: A volatility smirk, particularly a steep one, suggests the market has a directional bias towards potential downward price movements for the underlying asset. This is because OTM put options (offering downside protection) have higher implied volatility compared to ATM options. - Pricing of Options
Higher Costs for Protection: Options positioned in the “tail” of the smirk, particularly far OTM puts, tend to be pricier compared to their counterparts in a flat volatility scenario. This reflects the market’s inclusion of a higher risk of substantial price drops.
Potential for Skew Strategies: The smirk can create opportunities for options strategies that exploit the volatility difference between ATM and OTM options. However, transaction costs and other factors can make these strategies complex to implement. - Risk Assessment
Perceived Market Risk: The smirk’s steepness can serve as an indicator of perceived market risk. A sharper smirk suggests a market with heightened concerns regarding potential downside risks.
