Advanced Volatility Skew

Volatility skew is a critical concept in options trading, reflecting the market’s expectations of risk and potential price movements. Unlike the Black-Scholes model’s assumption of constant implied volatility, real-world options markets display skew due to investor behavior and market structure. Understanding skew enables traders to exploit mispricings and position themselves effectively in the market.

What is Volatility Skew?

Volatility skew describes how implied volatility (IV) changes across different strike prices. It occurs because options at different strikes do not trade at the same implied volatility, which reflects market participants’ risk preferences. This deviation provides insights into how traders price the probability of extreme price movements.

What Causes Skew?

Several factors contribute to volatility skew:

• Demand and Supply Imbalances: If more traders buy put options for protection, put implied volatility increases relative to calls.
• Institutional Hedging: Large institutions dynamically hedge positions, affecting IV at different strikes.
• Tail Risk Concerns: Investors often fear extreme downside risk more than upside risk, leading to a persistent put skew.
• Structural Market Effects: Certain asset classes (e.g., equities) naturally exhibit specific skew patterns due to economic fundamentals.

Types of Skew

Skew is not uniform and takes different shapes, each conveying unique market information:

• Smile: Implied volatility is highest for deep in-the-money (ITM) and deep out-of-the-money (OTM) options, common in currency markets.
• Smirk: A downward-sloping IV curve, often seen in equity options, where OTM puts have higher IV than calls due to crash risk.
• Forward Skew: Higher IV in OTM calls, indicating strong upside expectations, typically seen in commodity markets.

Trading Implications of Skew

Traders can exploit volatility skew by structuring trades that take advantage of IV mispricing:

• Backspreads: Profitable in environments where skew overprices downside risk.
• Ratio Spreads: Used to benefit from favorable IV discrepancies.
• Skew-Based Arbitrage: Traders can hedge using options at different strikes to capture mispricings.

Conclusion

Advanced volatility skew analysis provides a deeper understanding of market sentiment and risk perception. Recognizing different skew shapes and their causes allows traders to capitalize on market inefficiencies and refine their trading strategies to align with evolving volatility structures.