29
Jun
11

Volatility smile

As option trader, the most crucial thing one has to observe is Implied Volatility (IV). When IV of an option and its strike price is plotted, its curve is known as volatility smile. Volatility smile for FX options is U shaped curve which resembles smile. FX volatility smile curve implies that IV’s for At-the-money (ATM) options are lowest, and higher for In-the-money (ITM) and Out-of-the-money (OTM) options.

For equity options, volatility smile tends to be downward sloping. IV decreases as strike price increases. After 1987 US market crash, people are worried about rapidly falling share prices and buy OTM puts as insurance. OTM puts IV’s are higher than ATM and ITM puts.

In one of my previous post https://writingoptions.wordpress.com/2011/06/10/dead-cat-bounce-and-my-dream-company-reliance-communications/, I had written that Reliance Communications (RCom) options have higher IV’s. I thought I should plot volatility smile for RCom calls and puts.

RCom put exhibit typical bookish pattern of reverse skew with ATM puts having lowest IV’s. OTM puts have highest IV’s followed by ITM puts.

RCom Call exhibit forward skew with OTM calls having highest IV’s followed by ATM calls and ITM calls. Normally commodities exhibit forward skew when prices are expected to rise in future.

Reliance Industries (RIL) is struggling on various fronts and this reflects in its share price performance over the past several months. So I thought about plotting volatility smile curve for RIL also.

RIL puts exhibit downward sloping volatility smile curve with OTM puts having highest IV’s, followed by ATM and ITM puts.

RIL calls volatility smile curve exhibit a shape similar to that of currencies. Its shape is different from RCom call volatility smile curve.

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