What is a Volatility Smile?

Malcolm Tatum

The volatility smile is a pattern that is common in just about any type of investing activity involving shares of stock and different approaches to options. Essentially, the pattern serves as proof that any at the money options involved with the investment have a lower degree of risk or volatility than in the money or out of the money options. When placed on a graph, this pattern closely resembles that of a human smile.

Man climbing a rope
Man climbing a rope

One of the most important aspects of the investment process is accurately projecting the future movements of a given stock or other investment instrument. Ideally, the investor is able to identify opportunities that have a high chance of earning a significant return, while still keeping the amount of volatility or risk within limits that the investor feels is reasonable. The ability to detect the presence of a volatility smile with a given investment is one of the ways to determine if the opportunity is worth the risk.

The concept of a volatility smile is well-known in the process of quantitative finance. In this situation, a quantitative analyst will use the current pricing and assumed volatility of general options, then use the smile pattern to identity similar but more exotic options that demonstrate the potential to earn a higher return but without additional risk. It is then possible to match the pricing information obtained from this exercise with options currently on the market and determine which, if any, of those options should be purchased.

Calculating the implied volatilities and discovering this pattern can help investors avoid getting involved with various options that are beyond their personal comfort zones, while still allowing them to identify and buy investments that will help them reach their financial goals. The pattern of the volatility smile may also provide the investor with some insight into when a particular option should be sold in order to maximize the return and avoid a period of downturn that may last for an extended amount of time.

Brokers as well as other financial analysts make use of the volatility smile to counsel clients on how to invest wisely, and earn the best return possible, given the circumstances and personal preferences of the individual investor. Savvy investors who like to do their own research before buying and selling investments can also learn how to identify this pattern, and use it to determine how to manage their portfolios more effectively. As with all formulas and strategies associated with the process of investing, the pattern of a volatility smile must be understood as an indicator, and not the final word on the upward or downward movement of any option. While the smile can direct investors to options that show great promise, there is always some risk of losing money involved.

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