Volatility Surfaces

What is a Volatility Surface?

Of all the variables used in the Black-Scholes model, volatility is the only one that is not known with certainty. At the time of pricing, all of the other variables are clear and known, but volatility remains an estimate. The volatility surface is a three-dimensional plot where the x-axis is the time to maturity, the z-axis is the strike price, and the y-axis is the implied volatility. If the Black-Scholes model were completely correct, then the implied volatility surface across strike prices and time to maturity would be flat. In practice, this is not the case, as many factors affect its activity. Consequently, Dopex designed its own revolutionary version of the renowned volatility smile design.

The Dopex Volatility Smile Replica

A volatility smile is a common graph shape that results from plotting the strike price and implied volatility of a group of options with the same underlying asset and expiration date. Volatility smiles are the result of factoring the possibility of extreme events occurring into the pricing of options by setting further OTM IV to higher levels than ATM options. Accordingly, Dopex replicated an enriched version of the traditional Volatility Smiles approach that uses Implied Volatility and price feed fetched from Chainlink Adapters to employ within a function that retrieves a Volatility Smile graph that's based on Realized Volatility of past data.
When the implied volatilities for options with the same expiration date are mapped out on a graph, a form emerges in the form of a "Smile," hence its name.