The Volatility Smile and Skew
For the same stock and expiration, different strikes have different implied volatilities. Downside puts on stocks are often pricier: the market charges extra for "crash" insurance.
Risk warning: forex, CFDs, options, futures and crypto assets usually involve leverage or high volatility, and you can lose more than you put in. This lesson only teaches the concepts; all numbers are for illustration and are not investment advice.
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Text version · Advanced Option Strategies, lesson 9: “The Volatility Smile and Skew”
For the same stock and expiration, different strikes have different implied volatilities. Downside puts on stocks are often pricier: the market charges extra for "crash" insurance.
Every strike has a different IV
Textbook models assume every strike shares one volatility. In real markets, connect the implied volatility at each strike and you usually get a curved line: a volatility smile or a volatility skew.
Stocks: downside protection costs more
Stocks tend to fall faster than they rise, so everyone rushes to buy low-strike Puts as “crash insurance”, pushing up their IV; high-strike Calls end up relatively cheap. This is the left skew common in stock options.
Effect on strategies
Protecting with out-of-the-money Puts costs more than the model says; selling out-of-the-money Puts collects more, but you're taking exactly the risk the market fears most. To judge whether an option is expensive, compare it with the IV near the same strike.
Key takeaways
- Join up the IV at each strike and you usually get a "skew" (higher on one side) or a "smile" (higher at both ends), not the flat line textbooks assume.
- Stock options usually skew to the left: lower-strike puts have higher IV, because everyone rushes to buy crash protection.
- Puts that are equally far out of the money are often pricier than calls. To compare expensiveness, look at IV near the same strike.
Try it yourself
You can do these exercises in this lesson's interactive simulation:
- Default “Stocks: left skew”: how much do the $10 out-of-the-money Put ($90) and the $10 out-of-the-money Call ($110) each sell for? What's each one's IV?
- Look at the $90 Put: how many times the flat-IV price is the price based on the smile?
- Switch to “Flat”: what happens to the two options' IV and prices? This is the textbook assumption.
- Switch to “Smile”, then drag the strike to $110: is the upside Call's IV higher or lower than at the money? How does that compare with the left skew?
Quiz and explanations
- 1. What does volatility skew usually look like for stock options?
- Answer: Lower-strike puts have higher IV.Drops tend to come harder, demand for protection is high, and IV at lower strikes gets pushed up.
- 2. The stock is $100 in a left-skewed market. Which is more expensive: a put $10 out of the money ($90 strike) or a call $10 out of the money ($110 strike)?
- Answer: The put.With a left skew, the $90 put has higher IV than the $110 call; at the same distance, the put costs more (for illustration: about $0.47 vs. $0.17).
- 3. What does the shape of a "volatility smile" say the market believes?
- Answer: Both big rallies and big drops are more common than theory assumes.Both ends curl up, meaning extreme moves in both directions are priced higher. This shape is common in FX options.
Terms in this lesson
- implied volatility (IV) (Implied Volatility (IV)): The volatility backed out of an option's market price, reflecting the market's expectation of future swings; the higher the IV, the pricier the option.
- strike price (Strike): The price written into an option contract at which you can buy or sell.
- volatility skew (Volatility Skew): Implied volatility is higher on one side of the strikes than the other; for stock options, low strikes (downside protection) usually have higher IV.
- volatility smile (Volatility Smile): Implied volatility plotted across strikes is higher at both ends than in the middle, like a smile, meaning the market sees big moves either way as more likely than theory assumes.