Smile Models
A trader or investor holding a portfolio of options or other derivatives based on a given underlying asset —be it cryptocurrency, an index, or a stock— needs a mid-volatility surface to accurately mark the portfolio to market at any point in time.
The volatility surface is a financial object that provides the volatility for any given expiry and strike price. This mid-volatility surface is derived from the bid and ask prices quoted in the options market using a smile model, which involves a fitting process and an interpolation across expiries.
Using bid/ask quotes directly to mark a derivatives portfolio is not feasible because different positions might require different volatilities—some should use bid volatility and others ask volatility. For complex derivatives that cannot be easily replicated with vanilla options, it becomes unclear whether to use bid or ask volatility.
Therefore, it is essential to construct a mid-volatility surface. This approach offers a consistent and unique view of the portfolio's value and associated risks.