Volatility smiles are implied volatility patterns generated when option traders allow implied volatility to depend on the strike price. These smiles or graphs reflect the implied volatility as a function of the ratio of the option’s strike (or exercise) price to stock price.
Why is Volatility Smile Important?
Volatility smiles can be seen when comparing various options with the same underlying asset and same expiration date but different strike prices.
The smile shows that the options deep in the money (ITM) or deep out of the money (OTM) have the highest implied volatility. Options with the lowest implied volatility have strike prices at the money (ATM) or near the money.
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