What is volatility skew and how to use it.
“Happy birthday to skew!” —you gifted songwriters can fill in the rest. You have till October, but if you want to start planning now to celebrate the birth of one of our favorite trading concepts, know that the crash of 1987 introduced implied volatility (IV) skew.
Before that, it was assumed options could be priced with a single volatility (vol). So if the SPX was at $300, the theoretical value of the $280 put used the same vol input, say 35%, as the $320 call. On Black Monday, the market dropped more than anyone imagined it might. From that point on, the market valued puts (protection) as being worth a lot more than before.
On October 20, the market was pushing up the prices of out-of-the-money (OTM) puts because people were either hedging against, or speculating on, another big drop. That drove the IVs of those puts higher than equidistant OTM calls. Remember that IV is the volatility input for a theoretical option pricing model that makes the theoretical option value equal to the option’s market price. In practice, when the option’s market price goes up, all things being equal, the option’s IV goes up. When the market price of an option drops, so does its IV.
With vol skew, the IV of that $280 put might be 40%. And the IV of the $320 call might be 30%. The phenomenon of different IVs at different strike prices creates skew. For stocks and equity indices, skew is usually steeper toward the puts, whose IVs are higher than calls because the equity market typically fears a big drop more than it expects a big rally. For physical commodities, the skew can be steeper toward the calls, whose IV is higher than puts because the market fears a big price increase if there’s a shortage in that physical commodity.
You can explore volatility skew in two places on the thinkorswim® platform from TD Ameritrade. On the Trade page, go to the Option Chain to load up the “Impl Vol” column for the actual IV numbers. Or find the Product Depth and set “Value” to “Impl Vol” to get the skew’s graphic representation. Notice the shape of the skew looks like a smile.
Vol skew doesn’t predict where a stock or index might go. Just because the puts have a higher IV, and traders seem worried about a big selloff, doesn’t mean the market will drop. But the skew’s shape can be more or less steep at different times. And that might tell you if traders are more or less concerned about the magnitude of potential price changes. Are traders anticipating some future news event that could drive prices lower? If so, the skew on puts might get steeper, with consecutively OTM puts having much higher IVs. Or are traders looking for smooth sailing ahead? Then the skew on the puts might get flatter, with consecutively OTM puts having only slightly higher IVs.
In this way, IV can be used to judge overall market sentiment. You may not know what’s spooking the market. But if skew steepens, it often means the market fears greater downside risk. When a stock has an upcoming earnings announcement, the IVs of OTM puts and calls can both be higher—making both the call and put skew steep. That suggests the market sees the potential of a big up-or-down move if earnings are better or worse than expected. It’s not a perfect system, but you can let the skew tell you what the market may be thinking.
For retail traders, skew modeling may not be the best way to spend your time. You may want to use skew to help select a trading strategy for your market opinion. For example, are you bullish, and the put skew is steep? Then a short OTM put could potentially take advantage of that skew. Are you bullish, but the put skew is flat? Then a long call vertical might take advantage of the skew.
It’s never simple. And there’s much more to strategy selection than a “skew chat.” But this kind of analysis can give you an idea of how to approach IV skew. Now all you have to worry about is finding the perfect group of trader pals to sing the birthday ditty, and what kind of cake skew will most enjoy.
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