Volatility Lessons: Getting Skewed and Liking It

Want to hear a riddle? What makes options smile, traders frown, flattens when it’s quiet, and steepens at expiration? Give up? Vol skew.

Okay, maybe it’s not that funny (what do you want, the Sphinx of Thebes?). But volatility skew is an option geek’s favorite topic. All of it may sound complicated and it certainly can be. But it can also be simpler and ultimately more useful. Wanna get theoretical with skew? Get yourself a math degree and go to town. But if you want to know how skew works and how you can use it as a trader, read on.

Skewing the Math Speak

Definitions first. The “volatility” (vol) in volatility skew refers to an option’s implied volatility. This is not historical vol, or vol based on price changes in an underlying stock or index. When plugged into a theoretical option-pricing model, implied vol makes the option’s theoretical value equal to the option’s current market price.

Something “skewed” can be asymmetrical or twisted. Here, volatility skew refers to implied vols that are different from one strike to the next, or from one expiration to the next. A vol skew doesn’t mean something went wrong. The skew or asymmetry is really an artifact of the option-pricing models themselves, as well as the market’s anticipation of what the stock or index might do later on. And that’s some of the information you can glean from analyzing the skew.

More, “intra-month” skew refers to implied vols between individual options at different strike prices in a single expiration month. “Inter-month” skew refers to implied vols between different expirations—either at specific strike prices, or an overall estimate of implied vols across all options in a given expiration. For example, an intra-month skew describes the case of the XYZ Dec 90 put with a 25% implied vol, and the XYZ Dec 85 put with a 28% implied vol. Inter-month skew describes the case of the XYZ Dec 90 put with a 25% implied vol, and the XYZ Jan 90 put with a 30% implied vol.

Visualize Skew

Vol skew is how the market deals with discrepancies between option prices from theoretical models, and the market expectations of the magnitude of a stock or index’s potential price changes. Collective supply and demand and market activity determines an option’s fair value. That price equates to an implied vol. The option price moves freely, and implied vol moves up or down accordingly. So, implied vol is simply another way of seeing the market’s estimate of whether a stock or index might move enough to make that option in the money, and that’s what you can see when you look at vol skew.

How do we see it? The thinkorswim^® platform gives you two choices. The Trade page shows the skew numerically, while the Product Depth shows the skew graphically.

First, you’ll find skew under the Trade tab as in Figure 1.

1. From the All Products sub tab, click on the caret to the left of one of the options expirations in the Option Chain.
   
2. Select “Impl Vol, Probability, OTM, Delta” from the drop-down menus to see the implied vol of each option. 
   

As you scan across those numbers, you’ll see they’re not the same for each strike, and that they tend to increase, the further out of the money (OTM) the strike is. Implied option vols at the same strike can also be different in the various expiration months.

The second way to see skew is under the Charts tab as in Figure 2.

1. Click the Charts tab, then the Product Depth sub-tab.
   
2. In the upper right, click the View drop-down menu and select OTM. You’ll see a graph of OTM implied vols for all expirations available for a given stock or index.
   

Refine the graph by choosing certain expirations or strikes in the Series and Strikes menus, also on the upper-right-hand side.

Intra V. Inter

With intra-month skews, the lowest implied vol is typically the at-the-money strike or near it. As Figure 2 also shows, implied vols slope upward and away from the at-the-money, typical for stock and stock-index options. The slope for the implied vols of the lower strikes (corresponding to OTM puts) is also steeper than for higher strikes (corresponding to OTM calls).

Here, the put slope’s steepness relative to the call slope is the market’s way of saying it sees larger potential down moves—common for stocks. By contrast, given a fear of shortages and higher prices, commodities often have a steeper call vs. put skew. Generally, the steeper the skew, the higher the implied vols of OTM options. And the greater the likelihood the market sees the stock or index reaching OTM strikes.

In equity and equity-index options, the intra-month skew tends to make OTM calls cheaper than puts that are OTM by the same amount. That’s normal. Selling naked puts on stocks you’re thinking of buying anyway can be a good alternative to buying the stock outright if you’re willing to take on the risk. The shape of equity skews also tends to give OTM call verticals slightly higher prices than OTM put verticals. And selling call verticals on stocks on which you’re bearish can be an alternative to shorting the stock. These short premium strategies can be more attractive when overall vol is slightly higher and the skew is steeper on the put vs. call side.

With inter-month skew, the same is also true. If one expiration has a higher vol than another, the market may expect larger price changes coming by the expiration with the higher vol. One caveat: as expiration approaches option vega—the change in an option’s premium when volatility changes—decreases. The lower the vega, the larger the vol change required to make the option price change. At expiration, when OTM options have low prices and low vegas, their implied vols can be high and make the skew steep. This isn’t necessarily the market seeing large price changes at expiration (though it’s possible), but rather the confluence of expiration and low vega.

Inter-month skew is often most pronounced on stocks that have upcoming earnings or news announcements. Options in expirations close to news tend to have a higher implied vol because news events could induce stock-price changes. If you want a short premium strategy regardless of a news event, take advantage of higher vol in the inter-month skew—which make calendar and diagonal spreads more attractive. But remember that vol is higher for a reason. And the market anticipates larger price changes around news, which might be detrimental to some option strategies.

Ultimately, think of leveraging skew like playing darts in the wind. To hit the bull’s eye, you need to adjust how you throw the dart to account for the strength of a market breeze. Skew is similar. It doesn’t necessarily change your bullish or bearish stock bias—you’re still looking to hit the bull’s eye—but you can pick strategies that help you take advantage of skew’s influence on your dart and aim for more successful trades.