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Implied Volatility & Volatility Smile: Panoptic Vs TradFi
Understanding Market Sentiment & How It Relates to Options Pricing
Implied volatility and volatility smile are two concepts that underlie how the market prices options and perceives risk. In this post, we'll explore what they are, how they work, and what their role is in Panoptions.
Implied Volatility (IV)
Implied volatility is a measure of the expected future volatility of an underlying asset. It reflects market participants' expectations about how much the asset's price will move. Realized volatility, on the other hand, is a measure of the volatility in the past.
Why Does Implied Volatility Matter?
Higher IV means higher option prices, as the market expects more significant price swings, translating to a higher risk. Traders use IV rank and IV percentile to gauge whether options are expensive with respect to their historical averages.
How Does Implied Volatility Work in Panoptions?
Panoptions uses a "streaming premia" model, in which buyers pay sellers a small fee whenever a Panoption is in range. This fee is related to the amount of fees a UniV3 LP would make (plus a small spread). From this, option premia then depend on the fees collected in a pool, which in turn depend on the fee tier in UniV3 pool, volume, and tick liquidity. By comparing the cumulative premia of an at-the-money option to the actual fees collected by a UniV3 pool per unit of time, we can derive an IV for Panoptions that incorporate those quantities; indeed, in this setting, IV is given by
When we plot IV against different strike prices, we often see a "smile" pattern, AKA the volatility smile. This smile indicates that options with out-of-the-money (OTM) and in-the-money (ITM) strikes have higher IV than when at-the-money (ATM).
Reasons for the Smile
The volatility smile can be attributed to factors like outlier risk, market psychology, supply and demand, and trading activity. It's more pronounced for shorter-dated options, which are more sensitive to sudden price movements.
Volatility Smile in Panoptions
The volatility smile in Panoptions depends on the relation between traded volume and liquidity of the pool. Typically, there is more liquidity close to the current price, as shown below (now that’s a crooked smile).
How Do Panoptic IVs Compare to Traditional Finance Option IVs?
Both help assess the market's expectation of future price changes. However, Panoptic's IV formula is tailored to the unique structure of liquidity pools, whereas traditional finance option IVs are derived from option prices. In the figure above, for example, IV is smaller for higher ETH prices than for small ETH prices, suggesting bullish market sentiment. And if IV < RV, then LPs would be disincentivized to provide liquidity in that specific pool.
Whether vanilla options or Panoptions, IV is a crucial metric, helping traders gauge risk and make more informed decisions. Though each case is calculated differently, the concept remains the same: understanding market sentiment and price movement. By understanding implied volatility and volatility smile, traders can better understand how options are priced and use that knowledge to make smarter trading decisions.
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