Smile of Volatility and Volatility Curve: A Complete Guide for Traders

Understanding the structure of the options market begins with studying volatility charts. The volatility smile is a visual representation of how the market assesses risk at different price levels. The volatility curve consists of implied volatility indicators corresponding to various strike prices for ATM (at-the-money), ITM (in-the-money), and OTM (out-of-the-money) options. It is one of the key tools for analyzing market expectations and making trading decisions.

The volatility chart shows how implied volatility values change when moving from one strike price to another. When the chart is symmetric around the central point, it is called a volatility smile. If the chart is asymmetric with a clear shift to one side, traders refer to this pattern as a skew. Both variants provide insight into which risks the market perceives as more significant.

Horizontal and Vertical Curves: What’s the Difference

The volatility curve exists in two main forms, distinguished by their time dimension. Understanding these forms is critically important for choosing the optimal trading strategy.

Horizontal curve shows how the volatility of the same strike price changes when moving from one expiration date to another. This helps traders understand how the market assesses risk over time.

Vertical curve demonstrates the distribution of volatility across different strike prices within the same expiration period. Most professional traders focus primarily on the vertical curve, as it directly influences spread strategy selection and risk calculation.

Forward and Inverted Curves: Direction Matters

The direction of the volatility curve reveals market expectations regarding the future movement of the underlying asset. The difference between a forward and an inverted curve is crucial for understanding market sentiment.

Forward curve forms when options with higher strike prices show higher implied volatility levels compared to options at lower levels. A pronounced upward bend of the forward curve signals a likelihood of bullish movement. The market is willing to pay a premium for call options, reflecting optimistic forecasts about the asset’s price.

Inverted curve occurs when implied volatility increases at lower strike prices. The more pronounced the inverted curve, the higher the expectations of a price decline. Put options become more expensive, as the market considers them a more valuable insurance tool. Inverted curves are especially common in markets with short-selling restrictions or high costs associated with shorting — these instruments are mainly used for hedging positions.

Using the Volatility Smile in Options Trading

In practice, analyzing the volatility smile becomes a powerful tool for making trading decisions. The implied volatility chart allows easy identification of the curve type and its slope — and based on this, traders can develop a trading strategy.

The curvature of the volatility smile helps assess which options are overvalued and which are undervalued by the market. In a rising market, traders often employ bullish call spreads when the curve’s slope is weakly expressed. If the curvature is more pronounced, it may be advisable to switch to more cost-effective bullish put spreads. Analyzing spreads between options at different strike prices helps optimize the risk-to-reward ratio.

Monitoring the shape of the volatility curve becomes a daily practice for options traders, enabling them to adjust positions based on current market risk perception and the likelihood of directional movement of the asset.