Editor's Note: Options are not suitable for all investors. Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Please see the Characteristics and Risks of Standardized Options.
Table of Contents
Volatility skew describes how implied volatility varies across at-the-money (ATM), in-the-money (ITM), and out-of-the-money (OTM) options with the same underlying asset. It can reflect market sentiment and anticipation of upward or downward price movement.
Volatility skew most commonly refers to vertical skews, which compare options with the same expiration date but different strike prices. However, there are also horizontal skews, or time skews, which look at options with the same strike price, but varying expiration dates.
Learn more about how volatility skew works, why it matters to options traders, and how it relates to strategies like puts, calls, and spreads.
Key Points
• Volatility skew refers to the variation in implied volatility between at-the-money, in-the-money, and out-of-the-money options for the same asset.
• Investors can use volatility skew as an indicator to decide on buying or selling options contracts based on market sentiment and price movements.
• Horizontal skew examines options with varying strike prices and the same expiration date, while vertical skew examines those with varying expirations and the same strike price.
• Measuring volatility skew involves plotting implied volatility against strike prices or expiration dates, allowing traders to identify potential market trends and opportunities.
• Trading based on volatility skew can be risky, especially with complex strategies like vertical (strike-based) or calendar (expiration or horizontal) spreads, making it more suitable for experienced investors.
What Is Volatility Skew?
Volatility skew, also known as option skew, is an options trading concept that reflects the difference in implied volatility across in-the-money options, at-the-money options, and out-of-the-money options. These differences can appear across strike prices (vertical skew) or across expiration dates (horizontal skew).
The more common of these is the vertical skew, which investors may use to understand market sentiment. With vertical skews, implied volatility is compared across options contracts for the same underlying asset with the same expiration date but different strike prices. The strike prices may reflect varying levels of implied volatility, each of which can be plotted on a graph.
Volatility skewness refers to the slope of the implied volatility on that graph, which may help inform traders about potential market expectations. A balanced U-shaped curve is called a “volatility smile,” while an unbalanced downward curve is called a “volatility smirk.” Both of these may suggest a market expectation of upcoming price movements.
What Is Implied Volatility (IV)?
Implied volatility, denoted by the sigma symbol (σ), is an estimate of the volatility a given asset may experience between now and the contract’s expiration date. It’s basically the level of uncertainty that investors have about an underlying stock and how much they believe the stock’s price may fluctuate in either direction.
The volatility of an underlying asset changes constantly. The more the price of the asset changes, the more volatility it has. But implied volatility doesn’t necessarily follow the same pattern, because it depends on how investors view the asset and whether they believe it will have volatility. Implied volatility is usually shown using standard deviations and percentages over a particular period of time.
Option pricing assumes that options for the same asset that have the same expiration share the same level of implied volatility. In the Black-Scholes model, strike price is an input, but the assumption is that volatility remains constant across strikes. But investors are often willing to overpay for stock options when they think there is more volatility to the downside than the upside.
Different types of options contracts have different levels of implied volatility, and it’s important for traders to understand this when determining their options trading strategy.
💡 Quick Tip: Options can be a cost-efficient way to place certain trades, because you typically purchase options contracts, not the underlying security. That said, options trading can be risky, and best done by those who are not entirely new to investing.
What Does Volatility Skew Mean for Investors?
Implied volatility depends on supply and demand dynamics as well as investor sentiment about the options. The volatility skew may help investors better understand the market and decide whether to buy or sell particular contracts. It’s an important indicator for investors who trade options.
Stocks that are decreasing in price tend to have more implied volatility on the downside. If there is higher implied volatility in the underlying asset, the price of an option can increase, resulting in a downside equity skew.
If a skew has higher implied volatility, this can indicate that options premiums will be higher. So investors can look at volatility skews to find low- and high-priced contracts when evaluating whether to buy or sell.
There are, again, two types of volatility skew. Vertical skew shows the variation in implied volatility across options contracts that have different strike prices and the same expiration date. This is more commonly used by retail traders. Horizontal skew shows the difference in implied volatility across expiration dates for options contracts that have the same strike price.
How Do You Measure Volatility Skew?
Investors measure volatility skew by plotting implied volatility values across strike prices or expiration dates. For example, with a vertical skew, a trader could look at a list of bid/ask prices for options contracts for a particular asset that expire on the same date. They often take the midpoint of the bid/ask option prices to estimate implied volatility (especially in liquid markets) and chart those values out.
The tilt of the skew can shift over time based on changing market sentiment. Observing these changes may help investors identify potential market trends to inform skew-related strategies. For instance, if the stock price increases significantly, traders might view it as overbought and anticipate a potential pullback. This can shift the skew, steepening its curve and reflecting increased demand for at-the-money or downside put options.
There are five factors that influence the price of options:
• Underlying stock or asset market price
• Strike price
• Time to expiry
• Interest rate
• Implied volatility
Investors can calculate the volatility at different strike prices and graph those out to see the volatility skew.
Get up to $1,000 in stock when you fund a new Active Invest account.*
Access stock trading, options, alternative investments, IRAs, and more. Get started in just a few minutes.
How Do You Trade With Volatility Skew?
As mentioned above, the two types of volatility skew are horizontal and vertical. These can both be used in options trading.
Vertical Skew
Investors tend to use vertical skew to try to determine market expectations and sentiment, and it is more commonly referenced than horizontal skew. Also referred to as volatility skew and option skew, vertical skew, as mentioned earlier, looks at the variation in implied volatility across strike prices for options that have the same expiration date.
Two common skew patterns that may indicate upcoming price movements are, as noted above, the smile and the smirk:
• Volatility Smile: Implied volatility is higher for both ITM and OTM than ATM, creating a U-shaped curve.
• Volatility Smirk: Implied volatility is higher for OTM puts than OTM calls, often reflecting demand for downside protection.
Using vertical skew, traders may find opportunities to trade debit spreads and credit spreads, evaluating which strike prices may offer favorable entry points.
For example, a trader might find a stock they believe will increase in value before its option contract expires. So they may want to use a bull put spread to buy in hopes of profiting bull put spread for a net credit, expressing a moderately bullish or neutral view, to profit from a price rise while limiting downside. They will have many strikes to choose from, so they can use vertical skew to identify potentially mispriced contracts based on relative implied volatility. The trader can identify a strike with favorable pricing, wait for the underlying to move or implied volatility to increase, and potentially sell the spread for a profit.
Horizontal Skew
There are many factors that drive changes in horizontal skew, such as product announcements, earnings reports, and global events. For instance, if traders are uncertain about the short-term future of a stock because of an upcoming earnings report, the implied volatility may increase and the horizontal skew may flatten.
Traders look for opportunities by using calendar spreads to look at the differences between option expiration implied volatility. Where there is implied volatility in a horizontal skew, there may be inefficient pricing that traders can take advantage of.
If the implied volatility is higher than expected in the front month, the option contract may be priced higher, which is referred to as positive horizontal skew.
On the other hand, if the implied volatility of the back month is higher than expected, this is known as negative horizontal skew or “reverse calendar spread.” In this situation, traders would sell the back month and buy the front month because they may profit if the price of the underlying asset increases before the back month contract expires.
For example, a trader might look at the market for a stock and find that there is a horizontal skew in the option calls, meaning traders are putting in buy and sell orders with the prediction that it’s more likely the stock will increase a lot in the long term than in the short term.
If the trader doesn’t think the current market predictions are correct, they might use a reverse calendar call spread, similar to shorting a stock and predicting it may decline. If the price of the stock plummets, both the long- and short-term contracts may lose value, and the trader could buy them back at a lower price than they sold them for.
In this case, the trader could also potentially profit if the implied volatility of the options decreases. They chose to sell when the implied volatility was high during the front month, so if the implied volatility decreases, they may be able to buy back at a lower price.
Although this has the potential to be a profitable way to trade, it also comes with high risk of potential loss because it’s a short call that requires significant margin. Stock exchanges require traders to have significant funds in their account if they want to place this type of trade.
💡 Quick Tip: Before opening any investment account, consider what level of risk you are comfortable with. If you’re not sure, start with more conservative investments, and then adjust your portfolio as you learn more.
The Takeaway
Options trading is popular with many investors, and volatility skew is one way for options traders to gauge market sentiment and assess relative pricing across strike prices or expirations. Traders might look at either horizontal or vertical skew to help determine an options strategy that aligns with their broader strategy.
However, options trading is risky. It’s generally more appropriate for experienced investors than for beginners. While investors are not able to sell options on SoFi’s options trading platform at this time, they can buy call and put options to try to benefit from stock movements or manage risk.
SoFi’s options trading platform offers qualified investors the flexibility to pursue income generation, manage risk, and use advanced trading strategies. Investors may buy put and call options or sell covered calls and cash-secured puts to speculate on the price movements of stocks, all through a simple, intuitive interface.
With SoFi Invest® online options trading, there are no contract fees and no commissions. Plus, SoFi offers educational support — including in-app coaching resources, real-time pricing, and other tools to help you make informed decisions, based on your tolerance for risk.
FAQ
What is a volatility skew?
A volatility skew is the difference in implied volatility across options with the same expiration date but different strike prices. Volatility skews reflect investor sentiment and demand for downside or upside protection. Traders may watch for steep or unusual skews as signals of potential market movement.
How to trade the market when volatility spikes?
When volatility spikes, options premiums often rise. Some traders may consider selling options to potentially capture high premiums, while others might use spreads or protective puts. These strategies can be risky and may not suit all experience levels.
How can I trade volatility?
Traders may attempt to trade volatility through options strategies that respond to implied volatility changes. These include straddles, strangles, and calendar spreads. The goal isn’t to predict direction but to benefit from volatility shifts. This approach may carry significant risk.
What is skewness in trading?
In options trading, skewness refers to the curve shape of implied volatility across strike prices. A balanced shape is called a volatility smile, while an unbalanced one is a volatility smirk. Skewness helps traders identify where the market is pricing in greater uncertainty.
Photo credit: iStock/Just_Super
INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
For disclosures on SoFi Invest platforms visit SoFi.com/legal. For a full listing of the fees associated with Sofi Invest please view our fee schedule.
Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
Disclaimer: The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
Utilizing a margin loan is generally considered more appropriate for experienced investors as there are additional costs and risks associated. It is possible to lose more than your initial investment when using margin. Please see SoFi.com/wealth/assets/documents/brokerage-margin-disclosure-statement.pdf for detailed disclosure information.
SOIN-Q325-013