Implied Volatility Lessons: Getting Skewed

What makes options smile, flatten, and steepen? Volatility skew.

It may sound complicated, and it certainly can be. But volatility skew can also be simple and useful for option traders, especially during volatile times in the markets such as the tech bubble burst, housing meltdown, and COVID-19 pandemic. So how does volatility skew work and how can you use it when markets are volatile? First, you’ll need to know about implied volatility or IV.

Definitions First 

The “volatility” (vol) in volatility skew refers to the implied volatility of an option. And if you’re an option trader, you know that implied volatility changes often, which is why it’s a good idea to keep an eye on volatility skew.

In options trading, volatility skew refers to IVs that’re different from one strike to the next or from one expiration to the next for the same underlying asset. When the market takes you for a wild ride, you may see the IV for some options increase. That skew or asymmetry is really the market’s anticipation of what the stock or index might do later on. 

Two terms to get familiar with when understanding volatility skew are “intra-month” and “inter-month” skews. Intra-month skew refers to IVs between individual options at different strike prices in a single expiration month. “Inter-month” skew refers to IVs between different expirations—either at specific strike prices, or an overall estimate of IVs 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% IV. Inter-month skew describes the case of the XYZ Dec 90 put with a 25% IV, and the XYZ Jan 90 put with a 30% IV.

Visualizing Skew

Volatility skew is an indication of how the market deals with discrepancies between options prices from theoretical models. It also represents the market’s expectations for the magnitude of the potential price change of a stock or index. Options prices move, and IV moves up or down accordingly. So IV 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. That’s what you can see when you look at vol skew.

How do we see vol skew? There are two ways—numerically and graphically. We’ll start with the numerical visualization (see figure 1).

1. On the thinkorswim platform from TD Ameritrade, select the Trade tab. 
2. From All Products, select the caret to the left of one of the options expirations in the Option Chain.
3. Select “Impl Vol, Probability, OTM, Delta” from the menus to see the implied volatility of each option. 

As you scan across the implied volatility of options in the option chain, 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 volatility at the same strike can also be different in the various expiration months.

Now we’ll visualize skew using volatility skew charts (figure 2).

1. On the Trade tab, either scroll down below the Option Chain and expand the Product Depth section, or select the Charts tab, then Product Depth.
2. In the upper right, select the Show menu and select OTM. You’ll see a graph of OTM IVs for all expirations available for a given stock or index.

Refine the volatility chart by choosing certain expirations or strikes in the Series and Strikes menus on the upper right.

Dynamics of Volatility Skew

With intra-month options skews, the lowest IV is typically the at-the-money (ATM) strike or close to it. As figure 2 also shows, implied volatilities slope upward and away from ATM, which is typical for stock and stock index options. The slope for the IVs of the lower strikes (corresponding to OTM puts) can be steeper than for higher strikes (corresponding to OTM calls).

The put slope’s steepness relative to the call slope is the market’s way of saying it sees larger potential down moves. This is common for stocks. In contrast, given a fear of shortages and higher prices, commodities often have a steeper call versus put skew. Generally, the steeper the skew, the higher the IV 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 options skew tends to make OTM calls cheaper than puts that’re OTM by the same amount. That’s normal. So if you’re looking to accumulate stock, there are certain options strategies you could use, such as selling naked puts or cash-secured puts, to achieve a similar objective. They can be a good alternative to buying the stock outright if you’re willing to take on the risk. OTM call verticals have 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 versus call side.

Keeping an eye on options skew can help alert a trader to extreme price moves. You never know when a black swan event is likely to happen, but it’s a good idea to be prepared with trading strategies that can help you take advantage of any extreme price moves that could occur in the stock markets.