The volatility surface of stock options is something that investors pay very close attention to, but it’s not always the easiest concept for the average person to understand. Understanding its complexities, we’re here to explain the basics of the volatility surface.
To understand the volatility surface, you must first know the basics of stock options and stock option pricing. There is plenty of option price data and historical options data out there to help investors execute well-informed trades, but deciphering this data and knowing how to use it to your advantage requires a bit of a learning curve.
In simple terms, the volatility surface of a stock option is a three-dimensional representation of a stock option’s volatility that exist because of differences in how the market prices that option and what stock option pricing models say the correct price should be.
Stock options are a type of equity that gives the owner of the option the right to execute a trade, although it is not required. A “call option” is one that gives the owner the right to purchase the option’s stock at a predetermined price, known as the strike price. This purchase must be done before an expiration date. A “put option” gives the owner the right to sell the option’s stock at a predetermined price before a specific expiration date.
Of the various factors that stock option pricing models use, the only one that is not known with certainty at the time is the option’s volatility. Volatility is an estimate for these models and the volatility surface is a three-dimensional plot that represents this estimate where the x-axis is the time to maturity, the z-axis is the strike price, and the y-axis is the implied volatility.
Is a model’s volatility estimate is completely correct, the volatility surface will be flat, but this is not typically the case. The volatility surface is usually far from flat and varies over time. The behavior of every option is different and the shape of the volatility surface will change as a result. The volatility surface shows that stock option pricing models are not always accurate and it is something that every investor should pay close attention to before trading.