Volatility skew refers to a technical tool that informs investors about the preference of fund managers, whether they prefer to write call options or not. Factors that impact a volatility skew include investor sentiment about the market and the relationship between the supply and demand of given options in the stock market.
Volatility skew is derived by calculating the difference between implied volatilities of in the money options, at the money options, and out of the money options. The relative changes in the volatility skew of an options series can be used as a strategy by options traders. Volatility skew is also known as vertical skew.
Volatility skew is a graphical representation of a characteristic of options contracts. Even when the strike price and date of maturity of multiple options contracts are similar, they may still see different implied volatilities assigned to them.
The term volatility skew refers to a technical tool that informs investors about the preference of fund managers, whether or not they prefer to write call options.
Volatility skew is based upon the implied volatility of an option, which is the degree of volatility of the price of a given security, as expected by investors.
It can be of two types: a forward skew or a reverse skew.
What is Implied Volatility (IV)?
Implied volatility (IV) refers to the degree of volatility of the price of a given security as expected by investors. It is essentially a forecast that investors can use as a metric while making investment-related decisions.
Investors can use IV to discern future fluctuations in the price of a security, and as a proxy to the market risk associated with that security. When the market is bearish, implied volatility increases because investors expect the prices of equity to decline in the future. Similarly, in a bullish market, investors expect the prices to rise over time, which means that implied volatility decreases.
How does Volatility Skew Work?
In most options pricing models, it is assumed that the implied volatility of two options that share the same underlying asset and expiration date must be identical. The similarity must not be affected by differences in the strike price of the option.
In the 1980s, options traders realized that in practice, when the strike price of an option was undervalued, investors were still willing to overpay for them. It implied that the perception of the investors was such that downside protection was more valuable to investors than upside fluctuations in prices, given that they attributed more volatility to downside price fluctuations.
In equity markets, money managers usually prefer to write call options as opposed to put options. Such a move away from the strike price is what causes a volatility skew.
The graphical representation of a volatility skew demonstrated the implied volatility of a particular option of a given set of options. When the curve of the graph is balanced, it is known as a volatility smile, and when the curve is weighted to a particular side, it is known as a volatility smirk.
What is a Reverse Skew?
In a situation where the implied volatility on the lower options strike is higher, the kind of skew that is observed is known as a reverse skew. It is most commonly observed in long-term options or index options. The reverse skew generally occurs when investors purchase put options to compensate for the risk associated with the security because they perceive market concerns.
What is a Forward Skew?
In a situation where the value of the implied volatility on higher options increases, the kind of skew that is observed is known as a forward skew. This is usually observed in the commodities market because a demand-supply imbalance can immediately drive the prices up or down. Commodities, such as agricultural items and oil, are most commonly associated with forward skews.
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