What is Volatility Skew and How Can You Trade It?

By Laurel Tincher · August 25, 2021 · 7 minute read

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What is Volatility Skew and How Can You Trade It?

What is Volatility Skew?

Volatility skew, also known as Option Skew, is an options trading concept that refers to the difference in volatility between at-the-money options, in-the-money options, and out-of-the-money options. These terms in options trading refer to the relationship between the market price and the strike price of the contract.

Options contracts for the same underlying asset with the same expiration date but different strike prices have a range of implied volatility. In other words, it’s a graph plot of implied volatility points representing different strike prices or expiration dates for options contracts.

Each asset type looks different on a graph but they tend to resemble a smile or a smirk, the volatility skewness is the slope of the implied volatility on that graph. A balanced curve is called a “volatility smile,” and if it is unbalanced to one side it is called a “volatility smirk.”

What is Implied Volatility (IV)?

Implied volatility, denoted by the sigma symbol (σ), is an estimate of the volatility that a particular underlying asset will have between the current moment and the time when the options contract for the asset expires. It’s basically the uncertainty that investors have about an underlying stock and how likely traders think the stock will reach a particular price on a particular date. 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 predict 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 have the same implied volatility, even if they have different strike prices. But investors are actually willing to overpay for downside-striked stock options because they think there is more volatility to the downside than the upside.

Different types of options contracts have different levels of volatility, and it’s important for traders to understand this when determining their options trading strategy.

What Does Volatility Skew Mean for Investors?

Volatility depends on supply and demand as well as investor sentiment about the options. The volatility skew helps investors 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 volatility. If there is implied volatility of an underlying entity, the price of an option increases, resulting in a downside equity skew.

If a skew has higher implied volatility, this means prices will be higher. So investors can look at volatility skews to find low- and high-priced contracts to decide whether to buy or sell.

There are two types of volatility skew. Vertical skew shows the volatility skew of different strike prices of options contracts that have the same expiration date. This is more commonly used by individual traders. Horizontal skew shows the volatility skew of expiration dates of options contracts that have the same strike price.

How Do You Measure Volatility Skew?

Investors measure volatility skew by plotting graph points of different implied volatility of strike prices or expiration dates. For example, 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 take the midpoint implied volatility points from the bid/ask prices and chart them out.

The tilt of the skew changes over time as market sentiment changes. Observing these changes can give investors additional insights into the direction the market is heading, which they can use in skew trading. For instance, if the stock price increases in value significantly, traders might think it is overbought and therefore that it will decrease in value in the future. This will change the skew so its curve increases, showing more pressure for on-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.

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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 trading.

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 could 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 will be relatively more expensive, 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 can profit when 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 can use a reverse calendar call spread, similar to shorting a stock and predicting it will go down. If the price of the stock plummets, both the long- and short-term contracts will decrease in value and the trader can buy them back at a lower price than they sold them for.

In this case the trader can also 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 can buy back at a lower price.

Although this has the potential to be a profitable way to trade, it is also risky because it’s a short call that requires a lot of margin. Stock exchanges require traders to have significant funds in their account if they want to do this type of trade.

Recommended: Investment Risks and Ways to Manage

Vertical Skew

Many investors prefer trading with vertical skew because it is simpler than horizontal skew and requires less margin and, therefore, less risk. Also referred to as volatility skew and option skew, vertical skew looks at the differences between the implied volatility of different stock strike prices that have the same expiration date. Using vertical skew, traders can find opportunities to trade debit spreads and credit spreads, finding the best strike prices to buy or sell.

For example, a trader might find a stock they believe will increase in value before its option contract expires. So they want to find a bull put spread to buy to get profits when the price increases. They will have many strikes to choose from, so they can use vertical skew to identify which are the best trades, meaning those that are low or high priced. The trader can identify one with a good price to buy, wait until it increases and sell it for a profit.

The Takeaway

Options trading is popular with many investors, and volatility skew is one way for options traders to evaluate the price of options contracts. Traders might look at either horizontal or vertical skew to make a decision about whether an options contract purchase makes sense for their investing strategy.

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Photo credit: iStock/Just_Super

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