Volatility Skew – Uneven Pricing of Options

1. What Is Volatility Skew? Volatility skew refers to the pattern in implied volatility (IV) across different strike prices of options on the same underlying asset and with the same expiry. In a perfectly efficient market, IV should be constant across strikes — but that’s rarely the case. Instead, some strikes (especially deep OTM puts or calls) show higher or lower IV, forming a “skewed” curve. 2. Types of Volatility Skew There are three common patterns observed in volatility skew: Vertical Skew (Strike Skew): IV varies with different strike prices of the same expiry. Horizontal Skew (Term Structure): IV varies across different expiry dates. Smile/Smirk: When plotted, IV forms a curved shape — either symmetric (smile) or biased to one side (smirk). 3. Why Does It Happen? Volatility skew exists due to investor behavior, risk perception, and demand/supply for certain options: Put Options (especially deep OTM) often have higher IV because traders buy them for protection (insurance-like demand). Calls on high momentum stocks may also show elevated IV. In bear markets, put skew increases — reflecting fear of a crash. In bullish markets, call skew may show up in trending stocks. 4. Real Market Impact Traders often use skew to detect market sentiment — e.g., higher put IV may signal fear. Institutions may exploit skew via volatility arbitrage (e.g., buying undervalued options and selling overvalued ones). Skew also impacts option pricing strategies — butterfly spreads, ratio spreads, or straddles/strangles may behave differently when skew is involved. 5. How to Trade With Volatility Skew Skew Buying: If a far OTM option is underpriced due to low IV, it may be a good buy for a directional move. Skew Selling: Sell expensive strikes with high IV if you believe the volatility won’t spike further. Use skew patterns to adjust your strategy: choose broken wing butterflies or diagonal spreads instead of plain straddles.