Why Do Volatility Smile & Volatility Skew Happen?
As mentioned in Part 1, in more recent years, Volatility Skew pattern are more commonly observed than Volatility Smile pattern. For Call options, the Implied Volatility (IV) typically displays a Volatility Skew pattern, whereby IV is the highest for deep ITM options and then is decreasing as it moves towards OTM options. As discussed earlier, traders/investors are willing to buy an “expensive” deep ITM Calls because they can be used as a leverage tool to gain higher % return with lower capital, as compared to invest in the stock itself. Since deep ITM Calls have delta close to 1, they works like stocks, moving almost dollar for dollar with the stock price, but with much lower capital. In addition, when extreme price movements are expected, this may also mean that stocks can move sharply to the opposite direction. When the stock prices do not move as expected, ITM options would have lower risk of losing all the money than would ATM and OTM options, due to their inherent intrinsic value.
