Volatility Skew

Volatility skew or vertical skew is a concept in options trading that states the implied volatility of options contracts involving the same asset, for example, a stock or commodity with the same expiration date but different strike prices will differ. It offers investors information regarding fund managers' preferences.

The difference is impacted by the demand and supply relationship of certain options available in the market and investor sentiment. Traders can use the relative changes in an options series' vertical skew as a strategy. Usually, portfolio managers prefer writing call options rather than put options. This kind of move away from the strike price leads to a vertical skew.

• The volatility skew refers to a technical tool indicating the shape of a curve traced by a security's implied volatility with reference to the strike price. Also called vertical skew, it is of two types — forward and reverse skew.
• This skew is horizontal and simple. Additionally, its margin requirement is low.
• A key difference between vertical skew and smile is that a vertical skew occurs as portfolio managers write calls instead of puts. That said, volatility skew occurs when implied volatility for puts and calls rises as the option's strike price moves away from the security's current price.

The volatility skew refers to the difference between in-the-money, out-of-the-money, and at-the-money options. This technical tool offers information regarding whether fund managers favor writing calls or puts. In the case of most options pricing models, one assumes that an option's implied volatility for the exact underlying must be the same irrespective of the strike price.

One can explain implied volatility as the uncertainty associated with the underlying stock of an option and the alterations triggered at the trading prices of different options. It is the widespread market view of the possibility that the underlying asset's price will reach a certain level. 

In the 1980s, options traders started to find out that individuals were prepared to overpay when an option's strike price was undervalued. This indicated persons perceived upside price fluctuations as less valuable than downside protection.

The representation of vertical skew is done graphically to give the demonstration of a specific options set's implied volatility. Typically, the options utilized share the exact strike price and expiration date. However, they sometimes have the exact strike price but not identical expiry dates.

Over time, the skew's tilt changes with the market sentiment. Observing the changes can offer traders extra insights into the market's future direction, which they can utilize in trading volatility skew. For example, if the price of a stock rises significantly, traders may deem the security overbought. As a result, they think that it will lead to a drop in value. This alters the skew; thus, the curve rises, demonstrating more pressure for downside or on-the-money put options.

Let us look at the different types of vertical skew.

#1 - Reverse Skew

One can observe a reverse skew where the implied volatility on the lower options strike is more. Individuals commonly see it in an index or long-term options. Typically, the reverse skew formation occurs when traders buy put options as compensation for the uncertainty associated with the financial instrument since they become aware of the market concerns.

#2 - Forward Skew

When the implied volatility value on higher options rises, the skew observed is forward. Usually, individuals can find this in the commodities market as an imbalance in demand and supply can instantly drive prices down or up. Usually, forward skews are associated with oil and agricultural items.

Let us look at a few volatility skew examples to understand the concept better.

Example #1

Suppose a trader, Sam, saw that the market was demonstrating an upward movement with the CBOE Volatility Index staying above 30. As a result, there was significant negative vertical or volatility skew for index options.

He identified that the iShares Russel 2000 ETF out-of-the-money or OTM put options traded at higher IV levels than at-the-money put options. As one gets further out-of-the-money, it is even more spread. He subscribed to the notion that the total volatility has a historical average. Moreover, he believed that the level of volatility would decrease on average. Hence, Sam used a ratio spread to profit from such a market.

This means he started purchasing options with lower implied volatility while selling those with higher implied volatility. Then, he offset the options' sales by a ratio of 2:1 to the purchases to take advantage of the negative vertical skew in the IWM OTM put options.

Example #2

In April 2015, the call option interest that outpaced the demand for puts on stocks of Chinese companies turned HSCEI or Hang Sang China Enterprise Index's volatility skew steeply negative. It was similar to 2007, the year in which the market peaked before plunging sharply.

A large number of traders decide to engage in volatility skew trading as it is much more straightforward than horizontal skew. Moreover, it has a lower margin requirement. This is why it involves less risk. Utilizing this concept, individuals can spot opportunities to trade credit and debit spreads, determining the ideal strike prices to purchase or sell.

For instance, traders may spot a stock that they think is likely to rise in value before the expiration of its options contract. Hence, they want to use a bull put spread to make profits when its price increases. They can choose from several strikes. Hence, they can utilize vertical skew to determine the best trades, which means the ones priced low or high. A trader can spot one having a decent price to purchase at, wait until its value rises, and then offload it to make a profit.

One must also remember that individuals can use ratio spreads to trade vertical skew and make financial gains.

Although volatility skew and smile might seem the same, there are certain differences between these two concepts. Therefore, people beginning their trading journey must know their distinct characteristics to avoid confusion and incorrect trading decisions. The table below highlights the key differences between volatility skew and smile.

This has been a guide to what is Volatility Skew. Here, we compare it with volatility smile, explain its types, examples, and how to profit from trading it. You can learn more about it from the following articles –

• Calendar Spread
• Block Trade
• Sharpe Ratio