Implied volatility tends to be lowest with ATM options. The more an option is ITM or OTM, the greater its implied volatility becomes. Volatility smiles are created by implied volatility changing as the underlying asset moves more ITM or OTM. A trader must be aware of what other factors are driving an option’s price and volatility. While implied volatility is one factor in options pricing, it is not the only factor.A single option’s implied volatility may also follow the volatility smile as it moves more ITM or OTM.Near-term equity options and currency-related options are more likely to have a volatility smile. Not all options will have an implied volatility smile.Options with the lowest implied volatility have strike prices at the money (ATM) or near the money.We provide some best-practice recommendations, including the explicit specification of the algorithmic choices and a warning against using off-the-shelf routines. The smile shows that the options that are furthest in the money (ITM) or out of the money (OTM) have the highest implied volatility. Thus, we document a previously unknown phenomenon that a portion of the volatility smile is not of an economic nature. When options with the same expiration date and the same underlying asset, but with different strike prices, are graphed for implied volatility, the tendency is for that graph to show a smile.
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