Volatility Smile

A pattern observed when plotting implied volatility across option strike prices, forming a curve that resembles a smile because out-of-the-money puts and calls tend to have higher implied volatility than at-the-money options. This phenomenon contradicts the Black-Scholes model's assumption of constant volatility and became particularly pronounced after the 1987 crash, when traders began pricing in the possibility of extreme tail-risk events. The shape of the smile varies by asset class and can shift into a "smirk" or "skew" depending on market conditions.