Trading Options in Turbulent Markets: Master Uncertainty through Active Volatility Management, 2nd Edition

Chapter 4

Volatility Skew: Smile or Smirk?

In 1986, traders used the Black-Scholes pricing model to compute the theoretical fair value of an options contract. At the time, most traders assumed that the same implied volatility would apply for all options contracts based on a single underlying stock and with the same expiration date. It was also assumed that all options contracts based on a single stock or stock index should trade with the same measure of volatility, and at-the-money calls and puts with the same strike price and expiration date should have the same volatility.

But that was before the crash of October 19, 1987. On a single day, the Dow Jones Industrial Index fell by 508 points, or 22.6 percent. During that month the index lost nearly ...