Volatility Skew Explained

What is Volatility Skew?

If you've ever looked at an options chain, you might have noticed something strange: out-of-the-money puts are consistently more expensive than out-of-the-money calls at equivalent distances from the current stock price. This isn't a pricing error—it's volatility skew, and it's one of the most important concepts in options trading.

Volatility skew (also called IV skew) describes the pattern where options at different strike prices trade at different implied volatilities, even though they're on the same underlying stock with the same expiration date. In most stocks and indices, puts have higher IV than calls, creating a downward-sloping "skew curve."

Here's a typical example: SPY is trading at $450. The 430 put (20 points OTM) might have an IV of 18%, while the 470 call (also 20 points OTM) has an IV of only 14%. Even though both options are the same distance from the current price, the put costs significantly more because of its higher implied volatility.

Why Does Volatility Skew Exist?

Volatility skew exists primarily because of crash fear and supply/demand imbalances. Let's break down the key reasons:

1. Crash Fear and Tail Risk

Markets don't fall slowly—they crash. The 1987 Black Monday crash, where the S&P 500 dropped 20% in a single day, permanently changed how traders think about downside risk. Since that event, investors have been willing to pay premium prices for downside protection.

Stocks can fall much faster than they rise. A 5% up day is rare and celebrated. A 5% down day triggers panic and fear. This asymmetry in market behavior creates asymmetry in option pricing. Put buyers are essentially buying insurance against catastrophic losses, and like all insurance, it costs more than the statistically expected payout.

2. Portfolio Hedging Demand

Institutional investors, fund managers, and retail investors with large portfolios constantly buy puts to hedge their long stock positions. This persistent buying pressure on puts drives their prices higher relative to calls.

On the other side, there's natural selling pressure on calls from covered call writers. If you own 1,000 shares of Apple, you might sell calls to generate income. But there's no equivalent "covered put" strategy creating natural selling pressure on puts (you can't easily short stock in your retirement account to sell puts against it).

3. Leverage and Margin Requirements

Selling naked puts requires significant margin (often 20% of the strike value), while selling covered calls requires only stock ownership. This makes it harder and more capital-intensive to sell puts, reducing the supply of put sellers and keeping put prices elevated.

Types of Volatility Skew

Not all skew looks the same. Different assets exhibit different skew patterns:

Standard Equity Skew (Reverse Skew)

Most stocks and indices exhibit "reverse skew" or "negative skew" where OTM puts have higher IV than OTM calls. The IV curve slopes downward from left to right. This is the classic "crash fear" skew we've been discussing.

Example: SPY at $450
- 430 put (10% OTM): IV = 18%
- 450 ATM options: IV = 15%
- 470 call (10% OTM): IV = 13%

Forward Skew

Some commodities and volatile individual stocks show "forward skew" where OTM calls have higher IV than OTM puts. This happens when traders expect potential explosive upside moves (like biotech stocks awaiting FDA approval or oil during supply disruptions).

Volatility Smile

In currency options and some other markets, both OTM puts and OTM calls have higher IV than ATM options, creating a "smile" shape. This reflects uncertainty about which direction the asset will move, but confidence that it will move significantly.

How to Measure and Analyze Skew

Professional traders use several methods to quantify and track volatility skew:

Put-Call IV Differential

The simplest measure: subtract the IV of an OTM call from an equivalent OTM put.

Skew = IV(25-delta put) - IV(25-delta call)

Typically, this number ranges from 2-8 percentage points. During market stress, it can spike to 10-15+ points. When skew is elevated (above 8), puts are expensive relative to calls—an opportunity to sell puts or buy call spreads.

Skew Index (SKEW)

The CBOE SKEW Index measures the perceived tail risk in the S&P 500. It typically ranges from 100-150, with higher values indicating increased crash fear. A SKEW reading above 140 suggests traders are paying unusually high premiums for OTM puts.

Term Structure of Skew

Skew isn't constant across expirations. Near-term options (0-30 days) often show more pronounced skew than longer-dated options (90+ days). This is because crash risk is perceived as more immediate, and gamma risk is higher in short-dated options.

Trading Strategies Based on Volatility Skew

Understanding skew creates several trading opportunities:

1. Sell Expensive Puts (When Skew is Extreme)

When the put-call IV differential exceeds 8-10 points, puts are overpriced relative to calls. Consider strategies that benefit from elevated put prices:

• Put credit spreads: Sell an OTM put, buy a further OTM put for protection
• Cash-secured puts: Sell puts on stocks you'd be happy to own
• Iron condors: Sell both puts and calls, but collect more premium on the put side

2. Buy Cheap Calls (Relative Value)

When puts are expensive due to elevated skew, calls become relatively cheap. For bullish plays, consider:

• Call debit spreads: Buy calls at a discount compared to puts
• Long calls: Lower IV means lower Vega risk
• Poor Man's Covered Call: Use LEAPS calls as stock replacement

3. Skew Arbitrage (Advanced)

Sophisticated traders exploit skew through strategies like:

• Risk reversals: Buy OTM calls, sell OTM puts (profit if skew normalizes)
• Put ratio spreads: Sell more expensive near-the-money puts, buy cheaper far-OTM puts
• Call butterflies: Exploit cheap call options to create high-probability trades

4. Skew as a Market Timing Indicator

Extreme skew readings can signal market conditions:

• Very high skew (SKEW > 140): Excessive fear, potential contrarian buy signal
• Flattening skew: Complacency returning, caution warranted
• Inverted skew (calls > puts): Speculative mania, often precedes corrections

Common Mistakes When Trading Skew

Real-World Examples of Volatility Skew

Example 1: March 2020 COVID Crash

During the March 2020 market crash, SPY's volatility skew exploded. 30-day 25-delta puts had IVs above 70%, while equivalent calls were at 40%—a skew differential of 30 points! This extreme skew signaled peak fear. Traders who sold put spreads after skew peaked and started contracting made substantial profits as volatility normalized.

Example 2: Tesla's Forward Skew (2020)

In late 2020, Tesla briefly exhibited forward skew, with OTM calls more expensive than OTM puts. This reflected speculation about explosive upside potential. When skew inverted (calls > puts), it often signaled near-term price tops as excessive speculation entered the market.

Key Takeaways