Volatility Skew

Understanding the Volatility Skew

If you're new to trading, you may have heard about the term Volatility Skew but weren't quite sure what it means. To put it in simple terms, Volatility Skew is a term used in options trading, which refers to the disparity in implied volatilities across different strike prices in the same expiry cycle. It is a measure of how the perceived risk, reflected in the options prices, changes across various strike prices.

The Mechanics of Volatility Skew

In a perfectly balanced market, the volatility would be the same across all strike prices, creating what's known as a 'flat volatility surface.' However, in the real world, this is rarely the case. More often, we see a Volatility Skew, where options with strike prices lower than the current market price (out-of-the-money puts) tend to have higher implied volatilities than those with strike prices higher than the market price (out-of-the-money calls).

The skew occurs because market participants tend to be more concerned about significant market downturns and are therefore willing to pay more for downside protection, increasing demand for put options and raising their implied volatility.

Analysing the Volatility Skew

Understanding the Volatility Skew can provide valuable insights into market sentiment. A steep skew may indicate heightened fear or anticipation of a significant price move. Conversely, a flatter skew could suggest a more complacent or balanced market.

To the trader, the Volatility Skew can guide option strategy selection. For example, when the skew is high, it might be more advantageous to sell put options given their increased premium. On the other hand, when the skew is low, call options might become more interesting.

Conclusion

While the Volatility Skew can seem like a complex concept at first, it's an important tool in a trader's arsenal. By understanding Volatility Skew, traders can better predict market movements and optimize their trading strategies accordingly.