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Volatility Smile

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The options phenomena known as the volatility smile occurs when an at-the-money option (ATM) exhibits a lower implied volatility than either the in-the-money (ITM) or out-of-the-money (OTM) options. On a chart plotting implied volatility on the vertical axis and strike price on the horizontal axis, a u-shaped 'volatility smile' is formed. The volatility smile is graphed for options with the same expiration date. The volatility smile became more noticeable in equity and index options after the crash of 1987. Prior to observing the post-1987 volatility smile, it was assumed that there existed a constant and independent relationship between implied volatility and the strike price of options; the volatility smile was therefore a direct contradiction to one of the main assumptions in the Black Scholes Option Pricing Model. The presence of a volatility smile generally infers that there is more demand by option traders for in-the-money and/or out-of-the-money options rather than at-the-money options. The presence of a volatility smile then implies that the extrinsic values of the ITM and OTM options are greater than that of the ATM option. The volatility smile is generally a result of an anticipated increase in market volatility. To hedge against this expected volatility, traders are more likely to purchase and sell OTM and ITM options rather than ATM options; this excess demand is expressed by the shape of the volatility smile.

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