Volatility Skew

Volatility skew refers to the pattern where different strike prices on the same underlying and same expiration have different implied volatilities. In equity markets, OTM puts typically have higher IV than OTM calls, creating a downward-sloping curve when you plot IV against strike price. This pattern is also called the "volatility smile" or "smirk."

Why It Matters

Skew directly affects how options are priced at different strikes. If you assume all strikes have the same IV, your cost estimates and profit projections will be wrong. Skew is the reason a put spread and a call spread at equal distances from the stock price do not cost the same amount.

Understanding skew also reveals market sentiment. Steep skew (expensive OTM puts) means the market is paying a premium for downside protection — it fears a crash more than it anticipates a rally. Flat skew suggests the market views upside and downside risk more symmetrically. Changes in skew over time can signal shifting institutional positioning.

How It Works

The standard equity skew pattern:

• OTM puts (lower strikes): Highest IV
• ATM options: Moderate IV
• OTM calls (higher strikes): Lowest IV

This creates a downward-sloping line from left (low strikes) to right (high strikes), sometimes called a "smirk" because of its shape.

Why does skew exist?

1. Demand for protection: Institutions hold large equity portfolios and buy OTM puts as insurance. This persistent demand drives up put prices and, by extension, their IV.
2. Crash risk: Stocks tend to fall faster than they rise. The market prices in the asymmetry of returns — a 20% crash is more likely than a 20% one-day rally.
3. Leverage effect: When stocks fall, companies become more leveraged (debt-to-equity rises), which increases future volatility. This feedback loop makes downside volatility self-reinforcing.

Skew varies by product:

• Equity indexes (SPX, SPY): Steep skew — strong downside protection demand
• Individual stocks: Moderate skew, but can flatten or invert around events
• Commodities: Often have a "smile" — both OTM puts and OTM calls have elevated IV
• Around earnings: Skew can flatten as uncertainty applies to both directions

Trading skew:

• Selling OTM puts at elevated IV (due to skew) is a core premium-selling strategy
• Risk reversals (sell OTM put, buy OTM call) exploit skew by selling expensive IV and buying cheap IV
• Vertical spreads at different strikes have different risk/reward profiles partly because of skew

Quick Example

Stock EFG trades at $200. For 30-day options:

• $180 put (10% OTM): IV = 38%
• $200 ATM: IV = 30%
• $220 call (10% OTM): IV = 26%

The $180 put has 12 points more IV than the equidistant $220 call. This means the $180 put is relatively expensive. If you sell a $180/$175 put spread, you collect more premium than selling a $220/$225 call spread — even though both are equally far from the stock price. Skew creates this asymmetry.