What is a volatility smile and how it can help you hedge risk?

Introduction to the Volatility Smile

Understanding the various market dynamics has become increasingly important for traders and investors alike.

One such phenomenon is the “volatility smile,” which has implications for options trading, risk management, and market sentiment analysis.

In this article, we will provide a comprehensive overview of the volatility smile as it relates to cryptocurrency markets, discussing its causes, characteristics, and significance.

Understanding the Volatility Smile

The volatility smile is a term used to describe the pattern observed in the implied volatility of options across various strike prices.

Implied volatility, which is derived from options pricing models, such as the Black-Scholes model, is a measure of the market’s expectation of the underlying asset’s future volatility.

The volatility smile is generally seen as a U-shaped curve which plots implied volatility (IV) on the Y axis against strike prices on the X axis as shown in the diagram below.

Options with strike prices close to the current market price of the underlying asset (known as At The Money, or ATM) have the lowest implied volatility, and IV increases as strike prices get further away from the current price.

Big Smiles or Volatility Smirks?

Whereas a volatility smile is characterized by a symmetrical U-shaped curve, a volatility smirk exhibits an asymmetrical curve, with one side of the curve steeper than the other. A ‘smirk’ indicates that the market perceives a higher likelihood of significant price movements in one direction over the other.

For instance, a right-skewed smirk, as shown above, has higher implied volatility for higher strike prices, and usually implies a bullish market sentiment, while a left-skewed smirk (with higher implied volatility for lower strike prices) generally signifies a bearish market sentiment.

Causes of the Volatility Smile

Several factors contribute to the formation of a volatility smile in cryptocurrency markets:

• Market imperfections and liquidity: Market inefficiencies, such as the existence of bid-ask spreads and the impact of market makers on options pricing, can contribute to the volatility smile. Additionally, the limited liquidity in some cryptocurrency options markets may cause implied volatility to deviate from its expected values.
• Skewness and fat tails: The returns distribution of many cryptocurrencies tends to exhibit skewness and fat tails. This means that the probability of large price swings is higher than what is assumed in the more normal distributions used in options pricing models. The market may then adjust implied volatility to account for this higher likelihood of extreme price movements.
• Behavioural factors: Market participants may exhibit risk aversion or a preference for “lottery-like” payoffs, where bets with cheap premiums are placed far out of the money. This can result in a demand for options with strike prices far from the current market price which in turn pushes up the IV of these unlikely (but extremely profitable if they pay off) bets.

How the volatility smile can help with hedging

Understanding the intricacies of a volatility smile can be of great benefit to traders and investors when it comes to hedging risk in the markets.

Firstly, the shape and skewness of the volatility smile can provide critical information about market sentiment.

A symmetrical U-shaped smile indicates that the market is pricing in similar probabilities of large price movements in both directions, while an asymmetrical smirk suggests a higher likelihood of significant price movements in one direction over the other.

For example, in a bearish market environment with a left-skewed smirk, a trader holding a long position in the underlying asset could consider purchasing put options or implementing other protective strategies to hedge against potential downside risks.

Conversely, in a bullish market with a right-skewed smirk, a trader with a short position may choose to hedge with call options or other risk-mitigating tactics to protect against potential upside risks.

Secondly, the volatility smile can help traders identify potential mispricings or dislocations in the options market.

By comparing the implied volatility levels across different strike prices, traders can pinpoint options that may be overpriced or underpriced relative to the prevailing market conditions, and use this knowledge to implement volatility arbitrage strategies, where traders seek to profit from the discrepancies between the market’s implied volatility and their expectations of future volatility.

By engaging in these arbitrage strategies, traders can also reduce their exposure to directional price risk, further hedging their overall risk.

Characteristics of the Volatility Smile in Cryptocurrency Markets

The volatility smile in cryptocurrency markets can exhibit some unique characteristics compared to traditional financial markets due to:

• Higher overall volatility: Given the highly volatile nature of cryptocurrencies, the implied volatility levels tend to be much higher than those observed in traditional markets, such as equities and indices.
• Variation across cryptocurrencies: The shape and characteristics of the volatility smile can vary between different cryptocurrencies, reflecting differences in liquidity, market sentiment, and other factors specific to each asset.
• Time-sensitive nature: As the cryptocurrency market never closes (unlike the traditional options markets), it is continuously evolving, and thus the volatility smile can change over time, reflecting shifts in market sentiment and the fast pace of changes in outlook.
• Skewness and fat tails: The returns distribution of many cryptocurrencies tends to exhibit skewness and fat tails, meaning that the probability of large price swings is higher compared to traditional markets, and the market may adjust implied volatility to account for the higher likelihood of these more extreme price movements.

Interpreting a Volatility Smile

A volatility smile chart is a very simple graphical representation of the implied volatility of options contracts across various strike prices which helps investors to gain insights into market sentiment, risk expectations, and potential trading opportunities.

Here’s how to interpret volatility smiles on an options chart:

• Identify the axes: The horizontal axis (x-axis) of an options smile chart represents the strike prices of the options contracts, while the vertical axis (y-axis) represents the implied volatility levels.
• Observe the shape of the curve: The curve formed by connecting the implied volatility data points is the primary focus of the options smile chart.
• Compare ATM and OTM options: ATM options have strike prices close to the current market price of the underlying asset, while OTM options have strike prices significantly higher (call options) or lower (put options) than the current market price. In a typical volatility smile, the implied volatility is lower for ATM options and higher for OTM options.
• Analyze the skew: The skew of the curve can provide insights into market sentiment. If the curve is skewed to the right (i.e., higher implied volatility for higher strike prices), it may indicate a bullish market sentiment, as traders are expecting more significant upward price movements.
  Conversely, if the curve is skewed to the left (i.e., higher implied volatility for lower strike prices), it may suggest a bearish market sentiment, with traders anticipating downward price movements.
• Examine the steepness: The steepness of the options smile curve reflects the market’s expectations regarding the likelihood of extreme price movements. A steeper curve indicates that the market is pricing in a higher probability of large price swings, while a flatter curve suggests a lower probability of such events.
• Look for inconsistencies or irregularities: If there are noticeable inconsistencies or irregularities in the options smile chart, such as sudden spikes or dips in implied volatility, this may signal potential mispricing in the options market, providing potential trading opportunities for options traders.
• Consider the time factor: Keep in mind that options smile charts are time-sensitive, as market conditions and sentiment can change rapidly. For example, the smile on an options contract which expires soon will be dramatically different to one which expires in a few months' time.

Nope, it’s all blown my mind

Of course, analysing options markets isn’t for everyone. It’s complicated and there’s loads you need to think about on top of just volatility that can make you grimace, rather than smile.

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Bumper is launching soon and has the potential to seriously disrupt the crypto options market, as well as having some really unique features which could transform the entire industry.

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