A volatility smile is a term used in financial markets to describe the pattern that options' implied volatility tends to have across different strike prices. Typically, the implied volatility of options with at-the-money strike prices is lower than the implied volatility of options with strike prices that are either higher or lower.
The shape of a volatility smile is often U-shaped or m-shaped, hence the name "smile". This pattern occurs because options that are deeply out-of-the-money or in-the-money are more likely to experience extreme price movements, leading to higher implied volatility. Meanwhile, options that are at-the-money tend to have lower implied volatility, as they are considered to be more stable in price.
Traders and investors use the concept of a volatility smile to understand the market's expectations for future price movements and potential risks. It can also help them make more informed decisions about their options trading strategies.
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