Volatility Smiles

Volatility smiles take options models (such as Black-Scholes) and solves for implied volatility. Be aware that implied volatility and historical volatility are different. Historical Volatility lags current price by several weeks, but usually is near Implied Volatility, otherwise it creates a skew (but that's another post).

Looking at the graph, it forms a smile. That's because the demand on either side of the price is increasing. People are taking gambles, and driving the prices up. Options will generally have a lower volatility At the Money, whereas calls and puts on either side will be considerably higher, forming the smile shape.

The more extreme the price volatility, the more likely we are to see a large move in the underlying, not always though. Good smiles might be a good case for a long straddle, or other strategies.

(Volatility Smile for CPSL Sept '08, note the near term Smiles and the long term Smirks)

What happens when there is no smile, or rahter just a volatility smirk? The money isn't there yet, but as you watch over time, a skew becomes a smile; you know where the money is heading.