Volatility Skew Explained
The skew is typically the difference in implied volatility (IV) between out-of-the-money, at-the-money and in-the-money options. Volatility skew, which is affected by sentiment and the supply/demand relationship, provides information on whether fund managers prefer to write calls or puts. Akin to spreads, we here talk of the vertical skew in the same maturity. The B&S model assumed constant volatility across strikes, and has been followed by many debates, improvements and theoretical arcanes one needs not delve into to trade successfully. Put simply, if a XYZ stock trades at 50 and the 55 Call is cheaper than the 45 Put, we have a skew !
To refresh your memory on IV, please check back this page.
Let’s just quickly review the situation:
Using the standard Black Scholes option pricing model, we can compute the volatility Sigma of the underlying by plugging in the market prices for the options (Wikipedia has a number of maths references on this topic). For options with the same expiration date, the theory assumes the implied volatility (IV) to be constant, i.e. the same regardless of which strike price we use. However, IV is in reality different across various strikes, depending essentially on market expectations reflecting demand and supply for each option. This disparity is known as the vertical volatility skew. The IV versus strikes graph takes different shapes, from the better known volatility smile, to the smirk (forward / reverse skew).
Higher prices generally mean higher demand, hence higher IV. The distortion can also come from expectations at one end of the market, for instance, fear of a possible crash will increase hedging demands on lower strikes. The other interpretation is that options can in certain
environments be more palatable than the underlying vehicle, e.g. ITM calls rather outright purchase of the underlying. The forward skew pattern (i.e. higher IV on OTM Calls) is common for options in the commodities market. When supply is tight, businesses would rather pay more to secure supply than to risk supply disruption. For example, if weather reports indicates a heightened possibility of an impending frost, fear of supply disruption will cause businesses to drive up demand for out-of-the-money calls for the affected crops.
Does this affect options trading much ?
Yes, it does even though many traders still ignore it. The good news is that it has little impact on shorties / weeklies (all about Theta), and not so much our “bread & butter” Weirdor strategy.
Horizontal Skew ?
Likewise, there is a horizontal skew (although more natural, and not contradictory to the original B&S model) between calls (or puts) at the same strike across maturities. This is important to calendar traders. Since time is here of essence, we shall describe it along with Contango and Backwardation in a separate page.