If options were priced exactly as the classic Black-Scholes model assumes, every option on the same underlying with the same expiration — regardless of strike price — would show identical implied volatility. In real markets, this isn’t what happens. Plotting implied volatility against strike price for a given expiration typically produces a curved pattern rather than a flat line — a pattern known as the volatility smile, or in its more commonly observed equity-market form, the volatility skew.
This guide explains what the volatility smile and skew actually look like, why they exist despite the simplifying assumptions of standard options pricing models, the historical role of the 1987 crash in shaping the modern equity skew, how the pattern varies across different expirations (term structure), and how traders actually use this information in practice.
Key Takeaways
- The volatility smile refers to the pattern where implied volatility varies across different strike prices for options with the same underlying and expiration, rather than remaining constant as basic theory assumes.
- In equity markets, this pattern more commonly takes the shape of a skew, where out-of-the-money puts carry meaningfully higher implied volatility than out-of-the-money calls.
- The equity volatility skew became notably more pronounced after the 1987 stock market crash, reflecting a lasting repricing of downside tail risk.
- The skew reflects market participants’ collective pricing of crash risk and demand for downside protection, not a flaw in options markets or a pure arbitrage opportunity.
- Volatility term structure describes how implied volatility varies across different expirations for the same strike, adding another dimension beyond the strike-based smile or skew.
- Skew can be used practically to compare relative option pricing across strikes, structure certain spread strategies, and gauge market sentiment around tail risk.
- The existence of the smile and skew is one of the most direct pieces of real-world evidence that markets don’t fully satisfy the simplifying assumptions of basic options pricing models.
What the Volatility Smile Actually Looks Like
The Theoretical Expectation
The original Black-Scholes model assumes a single, constant volatility applies to the underlying regardless of the option’s strike price. Under this assumption, plotting implied volatility against strike price for options with the same expiration should produce a flat, horizontal line — every strike, whether deep in-the-money, at-the-money, or deep out-of-the-money, should show the same implied volatility.
The Observed Pattern
In practice, this flat line essentially never appears. Instead, implied volatility typically forms a curved pattern across strikes, often higher at both the low and high ends of the strike range relative to at-the-money strikes — a shape resembling a smile when plotted, giving the pattern its name. This smile shape is more commonly observed in currency and some commodity options markets.
Smile vs Skew: An Important Distinction
The Equity Market Pattern: A Skew, Not a Symmetric Smile
In equity and equity-index options specifically, the pattern more commonly observed isn’t a symmetric smile but a skew (sometimes called a “smirk”) — implied volatility rises meaningfully as strikes move lower (further out-of-the-money puts), while implied volatility for out-of-the-money calls typically rises much less, or sometimes even declines slightly, relative to at-the-money levels.
Why the Distinction Matters
This asymmetry is significant because it tells a specific story: equity options markets are pricing in meaningfully more probability, or more severe consequences, for a sharp downside move than for an equivalent-sized upside move — a pattern directly connected to the volatility skew concept introduced in broader options trading coverage. Understanding whether a given underlying’s pattern is closer to a true, symmetric smile or a pronounced downside skew provides real information about how the market is specifically pricing directional tail risk, not just overall uncertainty.
Why the Smile and Skew Exist
Fat Tails and Non-Normal Return Distributions
The Black-Scholes model assumes returns are normally distributed. Real financial returns, however, commonly exhibit fat tails — extreme moves occur more frequently than a normal distribution would predict. Since standard options pricing models built on normal-distribution assumptions would underprice options far from the current price if fat tails genuinely exist, the market corrects for this by pricing those far-from-the-money options with higher implied volatility than the model’s flat-volatility assumption would otherwise suggest.
Demand for Downside Protection
Institutional investors, portfolio managers, and individual investors alike commonly use out-of-the-money puts specifically to hedge against a sharp market decline, similar in concept to purchasing insurance. This persistent, structural demand for downside protection tends to bid up the price — and correspondingly the implied volatility — of out-of-the-money puts relative to what a simple, symmetric model would predict, contributing directly to the skew pattern observed in equity markets.
Leverage Effect
Some of the skew is also attributed to the leverage effect: as a company’s stock price falls, its debt-to-equity ratio effectively rises (assuming debt levels stay roughly constant), increasing the company’s financial leverage and, correspondingly, the expected volatility of its equity. This creates a genuine, fundamentals-based reason for implied volatility to rise as strikes (and by extension, the underlying’s hypothetical price at that strike) move lower, independent of any pure risk-aversion or insurance-demand explanation.
Supply and Demand Dynamics From Options Sellers
Some market participants, including certain institutional strategies, systematically sell out-of-the-money calls (for income generation, as in covered call strategies) while other participants are net buyers of out-of-the-money puts (for hedging), creating asymmetric supply and demand pressure across the strike range that reinforces the skew pattern beyond what pure risk-based explanations alone would produce.
The 1987 Crash: A Turning Point
Before October 1987
Prior to the stock market crash of October 1987 — a single-day decline of roughly 20% in major U.S. equity indices — equity options markets reportedly showed a considerably flatter implied volatility pattern across strikes, closer to what the basic Black-Scholes assumption of constant volatility would predict, without the pronounced downside skew commonly observed today.
The Lasting Impact
The 1987 crash demonstrated, in a single dramatic trading day, that a decline of a magnitude the normal-distribution assumption underlying standard options pricing models would have considered virtually impossible could, in fact, occur. Following this event, options markets permanently repriced downside tail risk more aggressively, and the pronounced equity skew — elevated implied volatility for downside puts relative to at-the-money and upside strikes — has persisted as a structural feature of equity options markets ever since, rather than reverting back to a flatter, pre-crash pattern.
A Direct Lesson About Model Limitations
This history offers a clear, concrete illustration of a point discussed more broadly in coverage of options pricing models: real markets learn from extreme events in ways that get permanently embedded into pricing, even when a specific model’s underlying mathematical assumptions haven’t changed — the market’s collective assessment of what’s actually possible shifted meaningfully and durably after 1987, and options pricing has reflected that shift ever since.
Volatility Term Structure: The Second Dimension
What Term Structure Describes
While the smile and skew describe how implied volatility varies across different strikes for a single expiration, volatility term structure describes how implied volatility varies across different expirations for a given strike (commonly at-the-money) — together, these two dimensions form a more complete picture sometimes called the volatility surface.
Normal (Upward-Sloping) Term Structure
During typical, calmer market conditions, implied volatility often increases somewhat with longer time to expiration — a pattern sometimes called contango in the volatility term structure — reflecting greater cumulative uncertainty over a longer time horizon.
Inverted (Downward-Sloping) Term Structure
During periods of acute, near-term market stress, this pattern can invert — sometimes called backwardation — with near-term implied volatility spiking above longer-term implied volatility, reflecting intense, immediate uncertainty about the near future that isn’t expected to persist at the same elevated level over a longer horizon. This inversion is itself a signal commonly monitored as an indicator of significant near-term market stress or an approaching known catalyst.
Why Term Structure Matters Alongside Skew
A complete view of an underlying’s volatility pricing requires considering both dimensions together — an option’s implied volatility depends on both which strike is being examined (the smile/skew dimension) and which expiration is being examined (the term structure dimension), and strategies that involve multiple expirations, such as calendar spreads, are directly built around exploiting or expressing a view on this term structure relationship specifically.
How Traders Use Skew in Practice
Evaluating Relative Value Across Strikes
Comparing implied volatility across different strikes for the same underlying and expiration can help identify whether specific options appear relatively expensive or cheap compared with others on the same underlying, informing decisions about which specific strike to select when constructing a position, rather than simply choosing a strike based on directional target alone.
Structuring Skew-Aware Spread Strategies
Multi-leg strategies discussed in broader options trading coverage, such as vertical spreads, can be constructed to specifically take advantage of the skew — for example, a put spread that sells a more expensive (higher IV) put closer to at-the-money while buying a relatively cheaper (lower IV, though still elevated relative to calls) further out-of-the-money put, capturing some benefit from the skew’s shape rather than simply expressing a directional view.
Reading Skew as a Sentiment Indicator
The steepness of the skew — how much more expensive downside puts are relative to at-the-money options or upside calls — is sometimes monitored as a rough gauge of market sentiment and perceived tail risk. A notably steepening skew can suggest growing market concern about downside risk, even before that concern shows up as an actual decline in the underlying’s price, while a flattening skew can suggest reduced perceived tail risk or reduced demand for downside protection.
Avoiding Naive Comparisons Across Strikes
Understanding skew helps avoid a common analytical mistake: assuming that an out-of-the-money put and an equally out-of-the-money call (in terms of distance from the current price) should be priced similarly, or comparing their implied volatilities as if a discrepancy necessarily represents a mispricing, rather than recognizing the structural, persistent skew pattern as an expected feature of equity options markets specifically.
Volatility Smile in Other Asset Classes
Currency Options: The True Smile
Foreign exchange (currency) options markets more commonly exhibit a genuinely symmetric smile pattern, rather than the pronounced downside skew typical of equity markets — reflecting the fact that a currency pair can move sharply in either direction without the same asymmetric “crash risk” dynamic that specifically characterizes single-direction equity market declines.
Commodity Options: Often the Opposite Skew
Some commodity options markets can show a skew in the opposite direction from equities — with out-of-the-money calls carrying elevated implied volatility relative to puts — reflecting the specific supply-and-demand dynamics of that particular commodity, such as concern about sudden supply disruptions driving prices sharply higher rather than the downside-crash-risk dynamic more typical of equity markets.
The General Lesson
The specific shape of the volatility smile or skew reflects the particular risk dynamics of the asset class and underlying in question — there’s no single universal pattern, and understanding why a specific market’s skew looks the way it does requires considering the specific risks and hedging demand characteristic of that particular asset class.
Frequently Asked Questions About the Options Volatility Smile
What is the volatility smile in options trading?
The volatility smile refers to the pattern where implied volatility varies across different strike prices for options with the same underlying and expiration, rather than remaining constant as basic options pricing theory assumes, typically forming a curved pattern when plotted.
What is the difference between a volatility smile and a volatility skew?
A volatility smile is a roughly symmetric pattern where both out-of-the-money puts and calls show elevated implied volatility, while a volatility skew is an asymmetric pattern, typical in equity markets, where out-of-the-money puts show meaningfully higher implied volatility than out-of-the-money calls.
Why do out-of-the-money puts have higher implied volatility than calls in equity markets?
This reflects several factors, including fat tails in real return distributions, persistent institutional and individual demand for downside protection functioning similarly to insurance, and the leverage effect, where falling stock prices increase a company’s effective financial leverage and expected equity volatility.
How did the 1987 crash affect the volatility skew?
Prior to the 1987 crash, equity options markets showed a considerably flatter implied volatility pattern across strikes; the crash demonstrated that extreme declines were more possible than normal-distribution-based models assumed, and the pronounced downside skew observed today has persisted as a structural feature of equity options markets ever since.
What is volatility term structure?
Volatility term structure describes how implied volatility varies across different expiration dates for a given strike, distinct from the smile or skew, which describes variation across different strikes for a single expiration, together forming what’s sometimes called the volatility surface.
Is the volatility skew the same for all asset classes?
No. Currency options often show a more symmetric smile pattern, some commodity options can show a skew in the opposite direction from equities, and the specific shape reflects the particular risk dynamics and hedging demand characteristic of each individual asset class.
How can traders use the volatility skew in practice?
Traders use skew to evaluate relative value across different strikes, structure skew-aware spread strategies that capture some benefit from the pricing pattern, and monitor skew steepness as a rough gauge of market sentiment and perceived tail risk.
Final Thoughts
The volatility smile, and its more commonly observed equity-market cousin the skew, is one of the clearest pieces of real-world evidence that markets don’t fully conform to the simplifying assumptions embedded in basic options pricing models. Born out of genuine fat-tail risk, persistent demand for downside protection, and permanently reshaped by the lessons of the 1987 crash, the skew isn’t a market inefficiency to be arbitraged away — it’s a structural, persistent reflection of how equity markets actually price the possibility of sharp declines.
The flat volatility assumption in basic options theory was always a simplification. The smile and skew are the market’s way of correcting for that simplification — and understanding why that correction takes the specific shape it does tells you something real about how the market perceives risk.
