Volatility Smile, underlying performance

2012-01-27T10:25:00.000+13:00

In What Does Individual Option Volatility Smirk Tell Us About Future Returns, Rice University researchers found that stocks with the steepest volatility smirks/smiles tend to under-perform least steep Vol-Smile counterparts by 10.9% per year on a risk-adjusted basis. The theory is that smart money tends to trade options, and therefore when option traders expect volatility to increase, they are usually right.

What causes volatility smiles?

Supply and demand of the options. If market participants mostly expect a coming dip in the underlying and buy up puts, implied volatility would naturally increase on the OTM (Out of the Money) puts, and vice versa. That is it.

How do we make money off this information?

This is pretty straight forward for traders of underlying instruments. Here's a paper where most of the research work's been done, Option Prices Leading Equity Prices. These guys show some interesting findings around earnings/corporate announcements off options statistics.

Ingenuity Space

Volatility Smile, underlying performance