Volatility Skew Definition

Volatility skew is the graphical illustration of the implied volatility of a set of security options at various strike prices or expiration dates. While implied volatility can be based on the underlying security, it should be the equivalent for all options at the same strike cost. In reality, the implied volatility of options can skew based on options traders’ expectations.

Volatility skew is a beneficial tool for gaining insight into the options market’s current viewpoint for security.

Implied Volatility

When understanding the significance of the volatility skew, it is essential to comprehend implied volatility.

Implied volatility is a crucial component of options pricing. It’s the outcome of the market’s expectation of the underlying security’s volatility throughout the option. The higher the expected volatility of an underlying security, the higher the premium demanded, making the options price greater as well.

The implied volatility should be equal to all the security options, but unfortunately, that is not always the case. This difference in implied volatility combined with the options’ price offers various insights into what market participants for that option are thinking.

How To Trade Using Volatility Skew

Normally, the volatility skew can be a tool to measure where options traders are willing to pay more or less for an option. This is based on various strike prices or expiration dates.

There are specific patterns that the volatility skew is projected to manifest, including, lower volatility as the strike price nears being ‘in the money.’ When a volatility skew deviates from the expectations, it signals an upcoming significant change in the underlying security price. Options traders use these deviations to forecast price changes in both the underlying security and several associated options.

Another common trading tactic involves comparing the volatility skew for put and call options. Usually, the volatility skew for call options will reflect the same volatility skew for put options but be slightly elevated in the overall implied volatility. This results from the general preference of trading calls over trading puts.

When the relationship is reversed or the volatility skews’ general state is different, this signals significant upcoming changes in the underlying security price or signals other opportunities to make profitable trades in the options market.

Concluding Thoughts

Volatility skew is an essential tool for options traders to quickly visualize the current market for specific security options in a more interpretable format. Deviations from standard volatility skew patterns can immediately inform traders about the security of the options.

The secret to an effective volatility skew is to understand the patterns, what they mean, and how any deviations from the normal patterns impact the options of that security.