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Volatility Skew

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Key Highlights

  • It indicates the differences in implied volatility for options with the same expiration date but differing strike prices.

  • Skew comes from how traders price risk based on supply, demand, and market sentiment.

What Is Volatility Skew?

It indicates the differences in implied volatility for options with the same expiration date but differing strike prices. It reflects how volatility expectations vary depending on how far an option is in or out of the money. Typically, out-of-the-money (OTM) options (those far from the current asset price) have higher implied volatility than at-the-money (ATM) options, showing that traders expect bigger price swings in certain directions. When you plot these differences, you get a curve called the volatility skew curve- a handy visual of market expectations.

Shapes of Skew

  • Volatility Smile: Implied volatility is higher for both OTM calls and puts, forming a “smile” shape on the graph, suggesting the market expects movement in either direction.

  • Volatility Smirk: Examines implied volatility differences among options with the same strike price but different expiration dates.

Why Does Volatility Skew Happen?

Skew comes from how traders price risk based on supply, demand, and market sentiment. For example, in stock markets, traders often worry more about crashes than booms, so OTM put options (betting on a price drop) tend to have higher implied volatility, creating a negative skew. Big events like earnings reports or market shocks can make skew more pronounced. This pattern helps traders gauge what the market’s expecting and plan their moves.

How Traders Use Volatility Skew?

By plotting implied volatility against strike prices or expiration dates, traders can see the skew’s shape and slope, which shift with market moods. This insight helps them spot trading opportunities, manage risks, or predict price trends. For instance, advanced strategies like calendar spreads rely on understanding skew, but they’re tricky and best left to seasoned traders.