The volatility smile is one of the most fascinating patterns in options markets. It contradicts what basic options theory predicts and reveals deep truths about how markets actually price risk. Understanding the volatility smile will make you a more sophisticated options trader and help you find mispriced options.
What is the Volatility Smile?
The volatility smile is a pattern where implied volatility is higher for both deep out-of-the-money (OTM) puts and deep OTM calls compared to at-the-money (ATM) options. When you plot IV against strike prices, the curve looks like a smile.
Visualize it: Imagine plotting IV on the y-axis and strike prices on the x-axis. ATM options are in the middle with the lowest IV. As you move to either side (lower or higher strikes), IV increases, creating a U-shaped or smile pattern.
Why Does the Volatility Smile Exist?
The Black-Scholes model assumes that stock returns are normally distributed and that IV should be constant across all strikes. But real markets do not work that way. The smile exists because:
- Fat tails: Real markets have more extreme moves than normal distribution predicts
- Jump risk: Stocks can gap up or down, especially on news
- Supply and demand: Traders buy OTM options for speculation and hedging
- Event risk: Earnings, FDA decisions, and other events can cause big moves
- Leverage effects: Volatility increases when stocks drop sharply
Volatility Smile vs Volatility Skew
These terms are related but different:
Key Differences
- Volatility Smile: Both OTM puts AND OTM calls have higher IV than ATM options. The pattern is relatively symmetric.
- Volatility Skew: Only one side (usually puts) has elevated IV. The pattern is asymmetric, tilted to one side.
In practice, equity markets often show a "smirk" - a combination where puts have more elevated IV than calls, but calls still show some elevation above ATM.
When and Where You See the Smile
The volatility smile appears more prominently in certain situations:
Markets with Strong Smiles
- Currency options: Classic symmetric smile due to two-sided risk
- Commodities: Both supply disruptions (bullish) and demand collapse (bearish) are risks
- Pre-earnings stock options: Big moves expected in either direction
- Biotech before FDA decisions: Binary outcomes create symmetric risk
Markets with Skew Instead of Smile
- Equity indices (SPY, QQQ): Strong put skew dominates, creating a "smirk"
- Large-cap stocks in calm markets: Put skew from hedging activity
What the Smile Shape Tells You
The shape and steepness of the volatility smile contains valuable information:
- Steep smile: Market expects potential for large moves in both directions
- Flat smile: Market is relatively complacent about tail risks
- Asymmetric smile (smirk): Market fears one direction more than the other
- Elevated overall level: High uncertainty across all scenarios
Trading insight: A steepening smile before earnings suggests the market is pricing in a bigger potential move. A flattening smile suggests expectations are moderating.
Trading Strategies Based on the Smile
Strategy 1: Butterfly Spreads
When the smile is steep, ATM options are relatively cheap. Butterflies centered at-the-money can profit from this pricing difference.
Butterfly Example
Stock at $100 with steep volatility smile:
- Buy 1x $95 call at 35% IV
- Sell 2x $100 calls at 28% IV (selling cheap ATM options)
- Buy 1x $105 call at 32% IV
The butterfly profits if the stock stays near $100. You are buying relatively expensive wings and selling the cheaper center, but the profit potential at ATM makes it worthwhile.
Strategy 2: Straddles and Strangles
When the smile is flat (unusual), buy straddles or strangles before expected events. You are getting OTM options cheaply relative to normal pricing.
Strategy 3: Ratio Spreads
Sell more OTM options than you buy ATM options, capturing the elevated wing IV. This works when you expect the stock to stay within a range.
Strategy 4: Calendar Spreads at Wings
When short-term smile is steeper than long-term smile, sell short-dated OTM options and buy longer-dated ones at the same strike.
The Smile Through Time
The volatility smile is not static. It changes based on market conditions:
- Pre-event: Smile steepens as traders buy OTM options for event exposure
- Post-event: Smile often flattens as uncertainty resolves
- Market stress: Smile becomes more skewed toward puts
- Calm markets: Smile tends to flatten overall
Measuring Smile Steepness
Traders use several metrics to quantify the smile:
- Wing volatility premium: Average of 25 delta put and call IV minus ATM IV
- Butterfly premium: 25 delta put IV + 25 delta call IV - 2x ATM IV
- Smile curvature: Second derivative of IV with respect to strike
Common Mistakes When Trading the Smile
- Assuming the smile is wrong: The smile exists for real reasons; do not ignore tail risks
- Overtrading wing options: Deep OTM options have wide bid-ask spreads
- Ignoring liquidity: The smile is most reliable for liquid strikes
- Not adjusting for events: Pre-event smile is very different from post-event
- Forgetting transaction costs: Smile trades often involve multiple legs
Practical Tips for Smile Trading
- Compare smile to historical norms: Is today's smile steeper or flatter than usual?
- Check smile across expirations: Different expirations have different smile shapes
- Use the smile to inform strike selection: Sell relatively expensive strikes, buy relatively cheap ones
- Watch for smile changes: Sudden steepening or flattening can signal trading opportunities
- Combine with other analysis: Smile trading works best when combined with directional or volatility views
Visualize the Volatility Smile
Pro Trader Dashboard displays IV across strikes, making it easy to see the smile pattern and identify mispriced options. Spot opportunities that other traders miss.
Summary
The volatility smile is a pattern where OTM options have higher IV than ATM options. It exists because markets have fat tails and traders demand protection against extreme moves. Understanding the smile helps you identify when options are relatively cheap or expensive. Use butterflies, ratio spreads, and careful strike selection to profit from smile patterns. Remember that the smile is not a market inefficiency to exploit but rather a reflection of real risks that you must respect.
Learn more about related concepts in our volatility skew trading guide or explore term structure trading.