Volatility skew has to do with the difference between put and call volatility. Sudden changes in volatility skew levels can indicate what the market may be anticipating.
How to use volatility skew to help understand your risks
Tracking volatility skew to anticipate upside or downside moves in stocks
Visualizing volatility skew of a specific option to help identify market sentiment
That was then, this is now. For options traders, now is a good thing, particularly when it comes to volatility (vol). Options volatility is typically divided into two time periods: before and after the 1987 crash. Before the crash, at-the-money (ATM) options in a given stock traded with the same implied volatility (IV) levels as those that were out of the money (OTM). This meant that OTM put options were priced far below fair value. But then the market crashed, and traders learned an expensive lesson: Never sell puts so cheaply ever again.
But raising the vol of every option, especially those at or near the money, could lead to slow death by time decay. The solution was to give each options strike a different, and adequate, IV level. Thus, volatility skew was born.
There are different ways to track skew. But one approach is to go to the option chain and compare the IV levels of the 30-delta put and 30-delta call. By subtracting call vol from put vol, you can see any changes in market maker sentiment over time. Note that you may not always find options displaying exactly 30 deltas, so just use the value closest to 30.
The option chain in Figure 1 shows a 30-delta call and a 29-delta put (close enough, although you could use 31). The difference in IV is 3.98% in favor of the puts,which tells us the market is more concerned about downside moves rather than upside moves.
Traders often track these values to find sudden changes in the skew level. If the difference between the call vol and put vol grows more negative, the market may be anticipating a downside correction. If the difference is positive, the market may be expecting a rally of sorts.
Within each stock, vol is different at every strike and expiration. To see this difference, select an expiration and explore the range of vol levels across all strikes. To find volatility skew for a given stock, fire up the thinkorswim platform from TD Ameritrade, then:
You’ll see a graph of the volatility curve, which if balanced, is often referred to as a “smile.” Sometimes, you may notice the slope for OTM puts may be steeper than the slope of OTM calls (a “smirk”). This implies the marketplace may be fearful of a correction. If the upside slope is significantly steeper than the downside slope, it may signal that traders are bracing for a possible sudden upside move.
Volatility skew is no crystal ball, but it’s a tool that can help you analyze what the market might be thinking.
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