Explain the Concept of ‘Volatility Smile’ in Crypto Options Pricing.
The volatility smile is a graphical pattern where options with strike prices far Out-of-the-Money (OTM) or deep In-the-Money (ITM) have higher implied volatility (IV) than At-the-Money (ATM) options. This suggests the market prices a higher probability of extreme price movements than predicted by the Black-Scholes model.
Glossar
Volatility Smile
Curve ⎊ The volatility smile, observed in options markets, represents the graphical depiction of implied volatility across different strike prices for options with the same expiration date.
The Volatility Smile
Phenomenon ⎊ The volatility smile is an empirical market phenomenon where implied volatility, derived from options prices, systematically differs across various strike prices for options with the same expiration date.
Crypto Options
Valuation ⎊ Crypto options, representing rights ⎊ not obligations ⎊ to buy or sell a cryptocurrency at a predetermined price before an expiration date, derive valuation from underlying asset price, time to expiry, volatility, and prevailing risk-free interest rates; models like Black-Scholes, adapted for crypto’s unique characteristics, are frequently employed, though parameter estimation presents challenges due to nascent market data and potential for manipulation.
Implied Volatility
Expectation ⎊ This value represents the market's consensus forecast of future asset price fluctuation, derived by reversing option pricing models using current market premiums.
Extreme Price Movements
Market Behavior ⎊ Extreme Price Movements, often termed "crashes" or "spikes," are sudden, sharp dislocations in the market price of a cryptocurrency, frequently driven by cascading liquidations or major news events.