Volatility skew refers to fact that options on the same underlying asset, with different strike prices, but which expire at the same time, have a different implied volatility.

When options first traded on an exchange, volatility skew was very different. Most of the time options that were out of the money traded at inflated prices. In other words, the implied volatility for both puts and calls increased as the strike price moved away from the current stock price — leading to a “volatility smile.”

That is a situation in which out-of-the-money (OTM) options (puts and calls) tended to trade at prices that seemed to be “rich” (too expensive). When the implied volatility was plotted against the strike price (see image), the curve was U-shaped and resembled a smile. However, after the stock market crash that occurred in October 1987, something unusual happened to option prices.

There is no need to conduct extensive research to understand the reason for this phenomenon. OTM options were usually inexpensive (in terms of dollars per contract), and were more attractive as something for speculators to buy than as something for risk-takers to sell (the reward for selling was small because the options often expired worthless). Because there were fewer sellers than buyers for both OTM puts and calls, they traded at higher than “normal” prices — as is true in all aspects of trading (i.e., supply and demand).

Ever since Black Monday (Oct 19, 1987), OTM put options have been much more attractive to buyers because of the possibility of a gigantic payoff. In addition, these puts became attractive as portfolio insurance against the next market debacle. The increased demand for puts appears to be permanent and still results in higher prices (i.e., higher implied volatility).

As a result, the “volatility smile” has been replaced with the “volatility skew” (see image). This remains true, even as the market climbs to all-time highs.

In more modern times, after OTM calls became far less attractive to own, but OTM put options found universal respect as portfolio insurance, the old volatility smile is seldom seen in the world of stock and index options. In its place is a graph that illustrates increasing demand (as measured by an increase in implied volatility (IV) for OTM puts along with a decreased demand for OTM calls.

That plot of strike vs. IV illustrates a volatility skew. The term “volatility skew” refers to the fact that implied volatility is noticeably higher for OTM options with strike prices below the underlying asset’s price. And IV is noticeably lower for OTM options that are struck above the underlying asset price.

NOTE: IV is the same for a paired put and call. When the strike price and expiration are identical, then the call and put options share a common IV. This may not be obvious when looking at option prices.

The inverse relationship between the stock price and IV is a result of evidence that shows us that markets fall much more quickly than they rise.

There currently exist a number of investors (and money managers) who never again want to encounter a bear market when unprotected, i.e., without owning some put options. That results in a continued demand for puts.

The following relationship exists: IV rises when markets decline; IV falls when markets rally. This is because the idea of a falling market tends to (often, but not always) encourage (frighten?) people to buy puts — or at least stop selling them. Whether it is increased demand (more buyers) or increased scarcity (fewer sellers), the result is the same: Higher prices for put options.

Volatility Skew. Part II

Many individual investors use options to enhance their earnings potential. Among those investors are those who prefer to take the easy way through their lives — and that includes how they handle investing and trading. Nothing wrong with that, but if you take the time to learn more, the chances are good that your performance will improve.

One way that the more sophisticated options trader can take advantage of extra knowledge occurs in situations in which the volatility skew (i.e., the “flatness” or “steepness” of the volatility curve) is changing.

• When the skew curve is relatively steep by historical standards, that represents a good opportunity to initiate trades that will earn a profit — if and when the curve becomes less steep and regresses toward its average value.

  Steep skew translates into higher prices (due to higher IV) for OTM put options and lower prices for OTM call options. The trader can select a spread that shorts those high-priced put options to gain a theoretical advantage. For example, the ratio spread allows the trader to sell a larger quantity of further OTM options — at an elevated price — then he/she buys. NOTE: Selling extra, or naked options may be too risky for you because the potential loss is essentially unlimited.

• When the current skew curve is relatively flat by historical standards, then traders can take advantage of that situation by owning OTM options at less than their usual cost. This strategy works for investors who prefer to own OTM options as portfolio protection, despite the fact that options lose value as time passes. It is also popular among traders who like to own OTM calls — just in case  of an unexpected market surge.

  The flat curve presents an opportunity for butterfly spread traders because that strategy involves buying the reduced-price OTM options and selling ATM (at-the-money) options.

The process for evaluating whether the current skew is flat or steep is not difficult, but it does take time to determine whether there is an edge that you can capture. If you plan to take advantage of as many opportunities as possible to gain a theoretical edge when trading options, it is worth your time to understand the basic concepts of options, and that includes volatility skew.