Reading Volatility Across Strikes

IV Changes Across Strike Prices

We have learned that Implied Volatility (IV) reflects the volatility embedded in an option's market price.

But there is an important point:

IV is not necessarily the same for every Strike Price.

If we look at the IV of different Call and Put Options for the same expiry, we may find that:

• ATM options generally have relatively lower IV.
• As we move away from ATM, IV generally increases.
• Far OTM options can therefore have higher IV than ATM options.

This creates a particular shape when IV is plotted against Strike Price.

Understanding the Volatility Smile

When the IV of different strikes is plotted on a graph, the curve can resemble a smile.

The middle of the curve represents the ATM options.

As we move towards either side, the IV rises.

This means that options at different Strike Prices can have different implied volatility even though they belong to the same underlying and expiry.

The shape is commonly called the Volatility Smile.

Why Does This Matter?

Suppose two options have the same expiry but different Strike Prices.

If one has significantly higher IV than the other, their premiums are being influenced by different volatility expectations.

Therefore, simply saying:

"This stock has an IV of 30%"

may not provide the complete picture.

A trader should also consider:

• Which Strike Price?
• Which expiry?
• How does its IV compare with other strikes?
• How does the current IV compare with historical levels?

Comparing IV Across Different Securities

The same idea applies when comparing different underlying assets.

For example, one underlying may have ATM IV of 25%, while another may have ATM IV of 50%.

It would be incorrect to immediately conclude that the first option is cheap and the second is expensive.

Different securities naturally have different volatility characteristics.

Therefore, we need a framework to compare current volatility with the underlying's own historical behaviour.

This is where the Volatility Cone becomes useful.

What Is a Volatility Cone?

A Volatility Cone is a way of comparing current implied volatility with historical realised volatility across different time periods.

It helps answer a practical question:

Is the current IV unusually high or unusually low compared with what the underlying has experienced historically?

To create a volatility cone, historical realised volatility is calculated for different periods before expiry.

The results are then used to create statistical ranges around the historical volatility.

How the Volatility Cone Works

Suppose we study an underlying over the past several months.

For each expiry period, we calculate the realised volatility over a particular number of days before expiry.

We then collect these historical volatility observations.

For each time-to-expiry period, we can calculate:

• Average volatility
• Upper volatility levels
• Lower volatility levels
• Standard deviation ranges

The resulting chart forms a cone-like structure.

The current option's IV can then be plotted against this historical range.

Reading the Volatility Cone

Imagine the current IV of an option is very close to the upper end of the historical volatility range.

This means:

Current IV is unusually high compared with historical observations.

The option may therefore be relatively expensive from a volatility perspective.

On the other hand, if the current IV is close to the lower end of the historical range:

Current IV is unusually low compared with historical observations.

The option may therefore be relatively cheap.

The source explains that options near the +2 Standard Deviation region can be considered costly, while options near the -2 Standard Deviation region can be considered cheap.

A Practical Example

Suppose an option currently has an IV of 40%.

Historical observations show that for the same time-to-expiry:

• Average IV = 25%
• +2 SD level = 38%

The current IV of 40% is above the historical +2 SD level.

This suggests that the option is trading at a relatively high volatility level.

A trader who expects volatility to return towards normal levels may consider strategies that benefit from a decline in volatility.

Now imagine another option has an IV near the historical -2 SD level.

Its volatility is unusually low compared with historical observations.

A trader expecting volatility to rise may consider strategies that benefit from an increase in volatility.

Volatility Cone Across Different Expiries

One advantage of the volatility cone is that it does not look at just one period.

It can compare volatility across different days to expiry.

For example:

• 10 days to expiry
• 20 days to expiry
• 30 days to expiry
• 60 days to expiry

This is important because an IV of 30% may be normal for one expiry but unusually high for another.

Therefore, volatility should always be considered in the context of time to expiry.

Using the Volatility Cone for Trading

The volatility cone can help traders identify options that appear relatively:

Expensive

Current IV is significantly above its historical range.

A trader may consider strategies that benefit if volatility falls.

Cheap

Current IV is significantly below its historical range.

A trader may consider strategies that benefit if volatility rises.

The basic idea is:

High Relative IV → Consider Selling Volatility

Low Relative IV → Consider Buying Volatility

However, this is not a guaranteed trading signal.

Volatility Is Mean-Reverting

One reason traders study historical volatility ranges is the idea that volatility can move back towards its typical levels.

For example:

Very High Volatility → May Cool Down

Very Low Volatility → May Increase

But volatility does not always immediately return to its historical average.

Market conditions can change, causing volatility to remain elevated or depressed for extended periods.

Therefore, the volatility cone should be used as a reference point, not as a standalone prediction.

Practical Insight

When comparing options, do not simply ask:

"Which option has the lower IV?"

Instead ask:

"Is this IV high or low compared with what is normal for this underlying and this time to expiry?"

This gives a much more meaningful comparison.

Common Beginner Mistake

A common mistake is comparing the IV of two completely different securities and assuming the one with higher IV is automatically expensive.

For example, an IV of 50% may be normal for one highly volatile stock but unusually high for another.

The underlying's historical behaviour matters.

Key Insight

IV becomes more useful when viewed in context.

The Volatility Smile helps us understand how IV differs across Strike Prices, while the Volatility Cone helps us compare current IV with historical volatility across different time-to-expiry periods.

Key Takeaways

• IV can vary across different Strike Prices.
• ATM options generally have relatively lower IV than options further away from ATM.
• Plotting IV across strikes can create a Volatility Smile.
• IV should not be compared without considering the underlying and expiry.
• A Volatility Cone compares current implied volatility with historical realised volatility.
• It can be constructed across different time-to-expiry periods.
• IV near the upper end of the historical range may indicate relatively expensive options.
• IV near the lower end may indicate relatively cheap options.
• The +2 SD and -2 SD levels can provide useful reference points.
• High relative IV may offer opportunities to benefit from falling volatility.
• Low relative IV may offer opportunities to benefit from rising volatility.
• The Volatility Cone is a decision-making tool, not a guarantee that volatility will immediately return to normal.