150  •   The Intelligent Option Investor
18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39
Strike Price
Oracle (ORCL) Implied Volatility
Implied Volatility (Percent)
160
180
140
100
120
80
40
60
20
0
Thinking about what volatility means with regard to future stock 
prices—namely, that it is a prediction of a range of likely values—it does not 
make sense that options struck at different prices would predict such radi-
cally different stock price ranges. What the market is saying, in effect, is that it 
expects different things about the likely future range of stock prices depending 
on what option is selected. Clearly, this does not make much sense.
This “nonsensical” effect is actually proof that practitioners 
understand that the Black-Scholes-Merton model’s (BSM’s) assumptions 
are not correct and specifically that sudden downward jumps in a stock 
price can and do occur more often than would be predicted if returns fol-
lowed a normal distribution. This effect does occur and even has a name—
the volatility smile . Although this effect is extremely noticeable when 
graphed in this way, it is not particularly important for the intelligent op-
tion investing strategies about which I will speak. Probably the most im-
portant thing to realize is that the pricing on far OTM and far ITM options 
is a little more informal and approximate than for ATM options, so if you 
are thinking about transacting in OTM or ITM options, it is worth looking 
for the best deal available. For example, notice that in the preceding dia-
gram, the $21-strike implied volatility is actually notably higher than the