Introduction to Options Skew

In options trading, understanding the concept of skew is crucial for accurately assessing market sentiment and pricing. Skew refers to the pattern of implied volatility across different strike prices, providing insights into how the market anticipates future movements of an underlying asset.

What is Options Skew?

Options skew, or volatility skew, describes the variation in implied volatility (IV) across options with different strike prices but the same expiration date. Typically, implied volatility is not uniform across all strikes; instead, it forms patterns that reflect market expectations and risk assessments.

Types of Skew

There are generally three types of skew observed in the options market:

• Put Skew: Common in stocks and ETFs, put skew occurs when out-of-the-money (OTM) puts have higher implied volatility than at-the-money (ATM) options. This pattern suggests that the market perceives greater risk to the downside, implying that while the most likely move is to the upside, the risk of a significant downside move is higher.
• Call Skew: Often seen when retail traders heavily buy calls, leading to higher implied volatility for OTM calls compared to ATM options. This indicates that the market views the risk as being to the upside, with the most likely move to the downside.
• Flat Skew: Occurs when the market is uncertain about future movements, resulting in similar implied volatility across all strikes. This suggests that the likelihood of both upward and downward moves, whether large or small, is similar.

Implications of Skew on Options Pricing

Skew significantly affects options pricing. For instance, higher implied volatility in OTM puts makes them more expensive, reflecting the market's assessment of greater downside risk. This pricing dynamic is essential for option sellers to understand, as it influences the premiums they can collect and the strategies they might employ.

Leveraging Skew in Trading Strategies

Savvy option sellers can exploit skew by structuring trades that align with prevailing market sentiments. For example, in a steep put skew environment, strategies like back ratio spreads can be advantageous. These involve buying an at-the-money put and selling two out-of-the-money puts, capitalizing on the higher premiums due to elevated implied volatility in OTM puts.

Additionally, understanding skew helps traders anticipate potential price movements and adjust their risk management strategies accordingly, enhancing their ability to achieve favorable risk-reward outcomes.

Conclusion

Grasping the concept of options skew is vital for traders aiming to navigate the complexities of the options market effectively. By understanding how implied volatility varies across different strike prices and what these variations indicate about market expectations, traders can make more informed decisions, tailor their strategies to exploit market inefficiencies, and enhance their overall trading performance.