Volatility Smile

The pattern where implied volatility is higher for deep in-the-money and out-of-the-money options than for ATM options.

The BSM model assumes constant volatility, but in practice, implied volatility varies across strikes (the 'vol surface'). A symmetric V-shape where OTM and ITM options have higher IV than ATM is called a 'smile'. An asymmetric skew where OTM puts have higher IV than OTM calls (common in equity markets) is called 'vol skew' or 'smirk'. The skew reflects market demand for OTM puts (crash protection). IV surface: IV varies across both strikes and maturities, captured in a 3D 'vol surface' chart.

Related Terms

Implied Volatility (IV)

The volatility that, when input into the BSM model, makes the model price equal to the market price of an option.

Historical Volatility (HV)

The realized standard deviation of the asset's returns over a historical lookback window, typically annualized.

Black-Scholes-Merton Model (BSM)

The foundational option pricing formula that gives the fair value of a European call or put as a function of spot, strike, rate, volatility, and time.