Securities and asset prices vary at a certain pace in the financial markets. Volatility is a frequent risk indicator since it implies price fluctuations and unpredictability. Traders and investors track volatility to make smart portfolio selections. Trading professionals utilize volatility surfaces to understand and evaluate volatility.
The volatility surface graphs option implied volatility versus strike price and expiry date. Implied volatility is the market’s anticipation of future volatility based on asset option prices. The volatility surface’s form might reveal the market’s risk perception and price changes.
There are three critical volatility surface elements traders should understand:
Volatility term structure:
The term structure of volatility is the link between implied volatility and option expiry. It is generally shown as a curve or set of curves on the volatility surface. The term structure usually suggests that longer-dated options have greater implied volatility. This is because investors are ready to pay more for longer-term price protection.
Skewness, Smile:
Skewness, or grin, is the volatility surface’s curve slope at various strike prices. Asymmetric curves show skewness, showing that options with higher strike prices have greater implied volatility. This means the market expects a substantial price drop in the underlying asset. When the curve slopes upward, options with at-the-money strike prices have more implied volatility than those with out-of-the-money or in-the-money strikes.
Volatility Arbitrage:
Traders arbitrage volatility using volatility surface information. Volatility arbitrage exploits perceived mispricings or implied volatilities across options or strike prices. Traders may benefit from market mispricing and volatilities convergence by purchasing or selling options depending on their respective implied volatilities.
Sources and References:
Investopedia: https://www.investopedia.com/terms/v/volatility-surface.asp
Wikipedia: https://en.wikipedia.org/wiki/Volatility_surface