Hi All ,
Black scholes Model assumes IV across all strike will be same. But If we see NSE option chain the OTM options have higher IV compared to ATM option( IV volatility skew or Vol smile)
What can be the reason ?
General answer which are not so convincing :
1)Market crashed in 1980 and since that day OTM options have higer IV.
Bigger players are hedging by buy buying OTM options so demand is more which drives the option prices up which causes OTM IV to rise
(If bigger players are buying who is selling them smaller players ? Bigger players are hedging bcas small players can make market move against bigger players )
OTM options are cheap so there is more Demand than supply (Also since premium are low, supply will be low , bcas the rewards for option writer is less so not many option writers will write these).
OTM options have High risk if they go into money , But in such case the ATM options have very bigger risk to begin with.