Skew Trading
Understand volatility skew — why puts are more expensive than calls — and how advanced traders exploit skew for profit.
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Not All Options Are Priced Equally
If you look at the implied volatility of options at different strikes, you will notice something: out-of-the-money puts have higher IV than at-the-money options, and OTM calls often have lower IV. This pattern is called volatility skew, and it exists for a structural reason that creates trading opportunities.
What Skew Looks Like
Plot IV against strike price for SPY options expiring in 30 days:
| Strike | Type | IV |
|---|---|---|
| $470 | OTM Put | 22% |
| $480 | OTM Put | 19% |
| $490 | Slightly OTM Put | 17% |
| $500 | ATM | 16% |
| $510 | Slightly OTM Call | 15.5% |
| $520 | OTM Call | 15% |
| $530 | Far OTM Call | 14.8% |
The $470 put has IV of 22% while the $530 call has IV of only 14.8%. That is a 7.2 percentage point difference. In dollar terms, the OTM put is significantly more expensive relative to its probability of expiring in-the-money than the OTM call.
This curve is called the volatility smile or smirk. In equity markets, it is almost always a smirk — tilted to the left, with puts more expensive than calls.
Why Skew Exists
Crash fear. After the 1987 crash, when the market dropped 22% in a single day, institutional investors permanently repriced downside risk. Fund managers buy OTM puts as portfolio insurance, willing to pay a premium. This structural demand inflates put IV.
Leverage and margin. When stocks drop, volatility increases because leverage ratios change — companies with debt become riskier as their equity value drops. This is called the leverage effect, and it makes large down-moves more volatile than up-moves of the same size.
Historical distribution. Stock returns are negatively skewed — large down-moves happen more suddenly and severely than large up-moves. Markets crash; they do not "melt up" at the same speed. Options are priced to reflect this asymmetry.
Trading Skew: The Concept
If OTM puts are overpriced relative to ATM options, a trader can sell the expensive puts and buy cheaper options to hedge. The edge comes from the skew premium — you are selling something that is systematically overpriced.
The simplest way to think about it: selling skew means selling options at strikes where IV is high and buying options at strikes where IV is lower.
Skew Trade 1: Put Ratio Spreads
Structure: Buy 1 ATM put, sell 2 OTM puts.
Example on SPY ($500):
- Buy 1 SPY $500 put at 16% IV for $7.00
- Sell 2 SPY $485 puts at 19% IV for $3.80 each ($7.60 total)
- Net credit: $0.60 ($60)
This trade profits if SPY stays above $485, drops moderately to $485, or even drops a little below. You lose only if SPY drops well below $485. The skew gives you an edge because the puts you sold are priced with higher IV than the put you bought.
Risk: Below $470, losses accelerate because you are short an extra put. This requires careful management and is not for beginners.
Skew Trade 2: Vertical Put Spreads (Selling the Steep Part)
Structure: Sell a put spread in the steep part of the skew curve.
When skew is steep (large IV difference between strikes), the OTM put you sell has inflated IV while the further-OTM put you buy has only slightly higher IV. You capture the skew premium within your spread.
Example: Sell SPY $485/$480 put spread. The $485 put has 19% IV and the $480 put has 20% IV. The 1% difference means your hedge is only slightly more expensive than normal, while the put you sell carries rich skew premium.
Compare this to selling a $510/$505 call spread where IV is only 15-15.5%. The put spread collects more premium for the same width because of skew.
Skew Trade 3: Risk Reversals
Structure: Sell an OTM put and buy an OTM call (or vice versa). This trade directly exploits skew because you sell the expensive side (puts) and buy the cheap side (calls).
Example:
- Sell 1 SPY $480 put at 19% IV for $3.80
- Buy 1 SPY $520 call at 15% IV for $2.50
- Net credit: $1.30 ($130)
You are bullish, collecting the skew premium, and your upside is uncapped. If SPY stays above $480, you keep the credit. If it rallies past $520, you also profit from the long call.
The risk: If SPY drops below $480, you are short a put with no spread protection. This is a directional and volatility trade combined — powerful but risky.
Monitoring Skew
Track skew by comparing the IV of 25-delta puts to 25-delta calls. This is called the 25-delta skew or risk reversal metric.
- Normal skew for SPY: 4-6 points (25-delta put IV is 4-6% higher than 25-delta call IV)
- Steep skew (above 8 points): Extreme fear of downside. Puts are very expensive. Opportunity to sell skew.
- Flat skew (below 3 points): Complacency. Puts are cheap relative to history. Consider buying protective puts.
Most options analytics platforms show skew charts. Check skew before selling put spreads — when skew is steep, your put spreads collect more premium for the same risk.
Skew Changes Over Time
Skew is not static. It steepens during selloffs (everyone rushes to buy puts) and flattens during calm rallies (put demand decreases). After a VIX spike, skew often remains steep even as overall IV declines — the market remembers the fear.
Understanding and trading skew separates intermediate traders from advanced ones. Most retail traders never look at skew. By incorporating it into your analysis, you gain an informational edge that improves every put-side trade you make.