What Is the Volatility Skew?
The volatility skew is the difference in implied volatility (IV) between out-of-the-money options, at-the-money options, and in-the-money options. The volatility skew, which is affected by sentiment and the supply and demand relationship, provides information on whether fund managers prefer to write calls or puts. It is also known as a "vertical skew." Volatilities are computed using the Black-Scholes option pricing model.
What Does the Volatility Skew Tell You?
A situation in which at-the-money options have lower implied volatility than out-of-the-money or in-the-money options is sometimes referred to as a volatility "smile" due to the shape the data creates when plotting implied volatilities against strike prices on a chart.
In other words, a volatility smile occurs when the implied volatility for both puts and calls increases as the strike price moves away from the current stock price. In the equity markets, a volatility skew occurs because money managers usually prefer to write calls over puts.
The volatility skew is represented graphically to demonstrate the IV of a particular set of options. Generally, the options used share the same expiration date and strike price, though at times only share the same strike price and not the same date. The graph is referred to as a volatility “smile” when the curve is more balanced or a volatility “smirk” if the curve is weighted to one side.
- The volatility smile shows that demand for options is greater when they are in-the-money or out-of-the-money, versus at-the-money.
- The volatility continues to increase as the options become increasingly in-the-money or out-of-the-money.
Volatility represents a level of risk present within a particular investment. It relates directly to the underlying asset associated with the option and is derived from the options price. The IV cannot be directly analyzed. Instead, it functions as part of a formula used to predict the future direction of a particular underlying asset. As the IV goes up, the price of the associated asset goes down.
The strike price is the price specified within an option contract at which the option may be exercised. When the contract is exercised, the call option buyer may buy the underlying asset or the put option buyer may sell the underlying asset.
Profits are derived depending on the difference between the strike price and the spot price. In the case of the call, it is determined by the amount in which the spot price exceeds the strike price. With the put, the opposite applies.
Reverse Skews and Forward Skews
Reverse skews occur when the implied volatility is higher on lower options strikes. It is most commonly seen in index options or other longer-term options. This model seems to occur at times when investors have market concerns and buy puts to compensate for the perceived risks.
Forward-skew IV values go up at higher points in correlation with the strike price. This is best represented within the commodities market, where a lack of supply can drive prices up. Examples of commodities often associated with forward skews include oil and agricultural items.