HOLLOW POINT TRADING
The Volatility Smile
The volatility smile is a pattern where implied volatility varies across different strike prices, even for options with the same expiration. When plotted on a graph with strike price on the X-axis and IV on the Y-axis, the curve often resembles a smile or smirk.
This challenges the Black-Scholes model's assumption that volatility is constant across all strikes. In reality, the market prices options at different IV levels based on supply, demand, and risk perception.
Why the Smile Exists
🎯 Key Reasons
- Fat Tails: Real markets have more extreme moves than normal distribution predicts
- Crash Risk: Downside protection is in high demand, making OTM puts expensive
- Leverage: OTM calls can offer lottery-ticket-like payoffs, increasing demand
- Supply/Demand: Hedgers often buy OTM puts, driving up their prices and IV
Types of Volatility Patterns
Volatility Smile
Both OTM puts AND OTM calls have higher IV than ATM options. Common in currency markets and commodities where big moves can happen in either direction.
Volatility Skew (Smirk)
OTM puts have much higher IV than OTM calls. Common in equity indices (S&P 500) where crash protection is heavily demanded. Also called the "volatility smirk."
| Strike Position | Typical IV (Equity Skew) | Why? |
|---|---|---|
| Deep OTM Put (80% of spot) | 25-35% | Crash protection demand |
| ATM Options | 15-20% | Base volatility expectation |
| Deep OTM Call (120% of spot) | 12-18% | Less demand, stocks "grind up" |
Trading the Skew
📈 Strategies That Benefit from Skew
• Put Spreads: Sell expensive OTM puts, buy cheaper further OTM puts
• Risk Reversals: Sell OTM put, buy OTM call (collect skew premium)
• Ratio Spreads: Exploit IV differences between strikes
⚠️ Risks to Consider
• The skew exists for a reason — crashes are real
• Being short OTM puts during a crash is devastating
• Skew can steepen during stress, moving against you
Term Structure
Volatility isn't just different across strikes—it's different across expirations too. This is called the term structure of volatility.
| Pattern | Description | What It Signals |
|---|---|---|
| Contango | Longer-dated options have higher IV | Normal conditions, uncertainty increases over time |
| Backwardation | Near-term options have higher IV | Fear/stress in the market, event premium |
The Smile Tells a Story
The volatility smile reveals market expectations and fears. Skewed toward puts? The market is worried about crashes. Flat or smiling? Uncertainty in both directions. Understanding the skew helps you identify relative value and avoid overpaying for options.
Professional traders don't just look at IV—they analyze the entire volatility surface.