Volatility skew, smile, smirk

[Toto_11]

2 quick dumb questions on this topic:

• is skew the same as smirk? If it looks like a smirk and talks like a smirk, then it must be a smirk. Or both, smile and smirk, are volatility skew?

• if there is a volatility smile, and market volatility is increasing, can we assume to take non directional hedge, that is straddle? Not sure if I am correct with this logic.

Thanks in advance!

[Greybeard_The_Elder]

Does this thread help? Cheers - good luck - you got this

Derivatives - volatility skew and volatility smile

Hello, I’m having some trouble with understanding the volatility skew and smile. Volatility smile: volatility is higher for ITM and OTM, compared to ATM. Is that because of the possible gains (ITM) and losses (OTM)? Skew: “to overpay for downside striked options on stocks. This meant that people were assigning relatively more volatility to the downside than to the upside, a possible indicator that downside protection was more valuable than upside speculation in the options market.” why…

[Greybeard_The_Elder]

In addition to that link, my short commentary: volatility smile and smirk relate more to market observations about option prices/values, rather than speaking to volatility strategies per se.

Volatility smirk = volatility skew. And it’s basically conveying the observation that OTM put options (low strike prices) often have higher implied volatilities (aka higher prices/values)… while OTM call options (high strike prices) have lower implied volatilities (they aren’t worth as much to folks as OTM put options which still have an insurance value to traders). So that’s why you see a smirk on the left-hand side, where the OTM put values are higher than the OTM calls on the right-hand side of the “smirk.” Remember that “implied volatilities” are what we’re talking about with these smiles and smirks - in other words, how much the options are worth. This smirk pattern is common for equity markets.

Volatility smile is the U-shaped observation you can often see when plotting implied volatility (aka value) for options at different strike prices but with the same maturity date. It observes that deep ITM or deep OTM options tend have higher implied volatilities (aka have higher value or are in greater demand) than ATM options. The folks in the previously-linked thread explain it pretty well I think. This U-shaped pattern is more common for the forex markets.

Cheers - good luck - you got this

[HerbsDelite]

Just remember Volatility smile and smirk are NOT NECESSARILY the same otherwise there would not have been the need to reclassify. There’s an element of “wrong way risk” more prominent in case of Put options writing.

The FRM course goes very deep unlike the CFAI in this regard. For whatever is worth pick up John Hull, Philip Jorian.

[Greybeard_The_Elder]

Definitely defer to HD here

[Toto_11]

I mean the qustion was if skew and smirk are the same? I understand all the underlying logics of smirk and smile, its just the terminology that confused me… but I found the answer in the old thread, that is smirk=skew

And that 2nd question bothered me whole night (the smile). If we have higher implied volatility for both calls and puts, and general market volatility is rising, it would imply greater demand for both, puts and calls, that is, the market doesnt actually know where the stock is going…

[HerbsDelite]

Two ways of dealing with it practically

1. Watch the volume bar for the straddle at St=X

2. Compare the gamma for both Call and Put at straddle St=X.

A lot of smile vs smirk related things should be clear

[Toto_11]

Thanks Herb, I think I get it!