What Do Volatility Smile and Volatility Skew Mean?
As you know, an option’s price comprises of Intrinsic Value and Time Value. In options pricing, there are 6 factors that affect an option’s price: option’s strike price, underlying stock price, implied volatility, time to expiration, interest rate, and dividend. An Intrinsic Value of an option is determined by the option’s strike price and the underlying stock price. And the major determinant of option’s Time Value is Implied Volatility and time remaining to expiration. Since Implied Volatility (IV) represents an estimate of future volatility, this factor is the most subjective. Therefore, Implied Volatility has been used by the market makers to “manipulate” the option’s price in order to balance the demand vs. supply of an option. For instance, when the demand of a particular option is relatively higher than its supply, traders/investors will be willing to pay a “higher” price for that option. This high demand would in turn push the price of that option upwards (through increased IV),
