Reasons implied vol curves across strikes
Question
When implied volatility is plotted against strike for options with the same expiry, the curve is not flat but smiles (or skews). Why?
Short answer
Because real return distributions are not lognormal with constant volatility. Actual returns have fatter tails (jumps, crashes) and volatility that is itself random and tends to rise when prices fall, so far out-of-the-money options are worth more than flat-vol Black-Scholes implies. Supply and demand add to it: after 1987, strong demand for protective out-of-the-money puts produced the steep downside skew seen in equity indices.
Adapted from Crack, Heard on the Street, Q2.33, p.29; question and answer rewritten by SelfMadeQuant.com.
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Open the worked solutionLessons behind this question
- Reading the Implied Vol Surface — Moneyness, Term Structure, and Quoting Conventions
- Option Mechanics: Calls, Puts, Moneyness, Intrinsic Value, and Exchange vs. OTC Markets
- Option Trading Strategies: Spreads, Combinations, and Payoff Engineering
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