Volatility Smile - Term Structure of Volatility

Term Structure of Volatility

For options of different maturities, we also see characteristic differences in implied volatility. However, in this case, the dominant effect is related to the market's implied impact of upcoming events. For instance, it is well-observed that realized volatility for stock prices rises significantly on the day that a company reports its earnings. Correspondingly, we see that implied volatility for options will rise during the period prior to the earnings announcement, and then fall again as soon as the stock price absorbs the new information. Options that mature earlier exhibit a larger swing in implied volatility (sometimes called "vol of vol") than options with longer maturities.

Other option markets show other behavior. For instance, options on commodity futures typically show increased implied volatility just prior to the announcement of harvest forecasts. Options on US Treasury Bill futures show increased implied volatility just prior to meetings of the Federal Reserve Board (when changes in short-term interest rates are announced).

The market incorporates many other types of events into the term structure of volatility. For instance, the impact of upcoming results of a drug trial can cause implied volatility swings for pharmaceutical stocks. The anticipated resolution date of patent litigation can impact technology stocks, etc.

Volatility term structures list the relationship between implied volatilities and time to expiration. The term structures provide another method for traders to gauge cheap or expensive options.