Volatility Skew in Options Trading: Insights & Applications

In financial markets, understanding risk is fundamental. Volatility skew is an intricate phenomenon that reflects the intricacies of risk perception and evaluation in options trading. It is a complex yet significant aspect of options trading that reflects the differing implied volatility levels across various strike prices or expiration dates for options on the same underlying asset. Let’s delve deeper into the concept to gain a clearer understanding.

What is Volatility Skew?

Volatility skew refers to the unevenness or asymmetry in implied volatility across different strike prices or expiration dates for options on the same underlying asset. Implied volatility is critical in options pricing , representing the market’s expectation of potential future price movements. When plotted on a graph, it typically showcases a slope that reflects varying levels of perceived risk for different options.

In a typical scenario, it is observed as higher implied volatility for out-of-the-money (OTM) put options compared to equidistant out-of-the-money call options. This pattern implies that market participants are willing to pay more for protective puts (options betting on a decline in the underlying asset’s price) than equivalent speculative call options (options betting on an increase in the underlying asset’s price). This skew often emerges due to market demand, supply dynamics, investor sentiment, and varying perceptions of risk associated with potential price movements.

It can vary across different assets, timeframes, and market conditions. For instance, during heightened uncertainty or impending market events, such as earnings announcements or geopolitical instability, it becomes more pronounced as investors seek protection against adverse price movements.

Traders and investors closely monitor this phenomenon as it offers valuable insights. They use this information to adjust their options trading strategies, assess risk exposures, and formulate informed trading decisions. Additionally, getting a clear understanding aids in constructing more nuanced risk management techniques and exploiting potential market inefficiencies in complex options trading.

Types

Volatility skew manifests in various forms, each conveying distinct information about market sentiment and perceived risks associated with options trading. Its primary types include:

1. Positive or Forward Skew

   In this scenario, implied volatility for out-of-the-money (OTM) call options is higher than OTM put options. Commonly observed in commodities markets , this skew indicates an anticipation of sudden demand spikes leading to significant price increases. It signals the market’s expectation of an upward price movement.

2. Negative or Reverse Skew

   A negative skew occurs when implied volatility for OTM put options surpasses that of OTM call options. This phenomenon is prevalent in equity markets, reflecting investor concerns about potential price drops. Investors are willing to pay more for put options to safeguard their investments. A negative skew suggests the market is expecting a downward price movement.

3. Smile Skew

   The smile skew manifests when implied volatility is higher for both OTM call and put options than at-the-money (ATM) options. This shape, resembling a smile on a volatility curve, is often witnessed in markets characterised by high uncertainty or the anticipation of significant price movements in either direction.

   Recommended Read: What is a Short Put Option?

4. Flat or No Skew

   When there is no discernible skew, the implied volatility remains consistent across all options, irrespective of their strike prices. This scenario suggests that the market doesn’t anticipate significant movements in either direction and perceives the risk uniformly across different strike prices or expiration dates.

   Understanding these volatility skew types enables traders and analysts to decipher market expectations and tailor their options trading strategies accordingly. Each type of skew unveils nuanced insights into investors’ perceptions of risk, facilitating more informed decision-making in options trading.

Formula

Calculating volatility skew involves assessing the implied volatility levels across different strike prices or maturities. One common method is by comparing the implied volatility of options at different strikes but with the same expiration date.

The formula determines the variance in implied volatility for options at different strike prices. One approach is to calculate the difference in implied volatilities between OTM call and put options with the same time to expiration. Here’s a simplified volatility skew formula:

Volatility Skew = Implied Volatility (OTM Put) – Implied Volatility (OTM Call)

This formula subtracts the implied volatility of out-of-the-money (OTM) call options from the implied volatility of OTM put options. Positive values suggest a positive skew, where OTM calls have lower implied volatility compared to OTM puts. In contrast, negative values indicate a negative skew, reflecting higher implied volatility for OTM puts compared to OTM calls.

Another approach involves using the average implied volatility for a range of OTM calls and put options. The formula in this case can be:

Here, ‘n’ represents the number of OTM options considered. By averaging the implied volatilities for OTM call and put options separately and then computing their difference, this method provides a broader view across multiple strikes.

It’s important to note that the calculation methods can vary based on preferences, market conventions, or the specific focus on a particular range of strikes or expiration dates. Additionally, various statistical techniques or interpolation methods might be employed when working with a continuum of strike prices to estimate implied volatility for strikes where options are not actively traded.

Moreover, traders and analysts often use specialised software or financial platforms with skew indicators or tools that automatically calculate and display skew values, simplifying the process and enabling timely decision-making in options trading strategies.

Example

Let’s consider an example involving a stock, “XYZ Ltd,” trading at Rs 500 per share in the Indian stock market . We’ll examine the implied volatilities of options with a 60-day expiration period.

Suppose the implied volatility for options on XYZ Ltd with a 60-day expiry is as follows:

• Out-of-the-money (OTM) call options with a strike price of Rs 550 have an implied volatility of 28%.

• Out-of-the-money (OTM) put options with a strike price of Rs 450 have an implied volatility of 32%.

Here, we can calculate it by finding the difference between the implied volatility of the OTM put option and that of the OTM call option:

Volatility Skew = Implied Volatility (OTM Put) – Implied Volatility (OTM Call)

Volatility Skew = 32% – 28% = 4%

In this instance, the positive skew of 4% indicates that the market perceives higher implied volatility for the OTM put options compared to the OTM call options. This skew suggests a slightly bullish sentiment or an expectation of potential downward movements, as reflected in the higher implied volatility for OTM puts relative to OTM calls within the given expiration period.

Practical Applications

Volatility skew, while abstract, holds practical significance in options trading and risk management. Its applications are diverse and crucial for traders, investors, and financial analysts in several ways:

• Options Pricing and Trading Strategies

  Volatility skew aids in options pricing models like the Black-Scholes model, where incorporating skew helps refine pricing accuracy. Traders use skew for options trading and its strategies, such as vertical spreads, straddles, or strangles, capitalising on perceived mispricings due to skew.

• Risk Management

  Understanding volatility skew assists in assessing and managing risk exposures. It helps determine optimal positions and hedge ratios, especially in portfolios containing options or volatility-based instruments.

• Market Sentiment Analysis

  Skew reflects market sentiment and expectations regarding potential price movements. Traders and analysts interpret skew changes to gauge market sentiment shifts, identifying trends or events that may impact asset prices.

• Investment Decision-making

  For institutional investors or fund managers, volatility skew is a vital input for portfolio allocation decisions. It influences asset allocation strategies and the selection of investment products, considering implied market volatility.

• Tailoring Trading Approaches

  Skew variations prompt traders to adapt their approaches. Positive skew may lead to adjustments favouring specific option strategies, while negative skew might signal a shift toward different risk management techniques.

• Market Risk Analysis

  Skew analysis assists in comprehending tail risks and the likelihood of extreme market movements, which are crucial for risk management models. This is particularly important during volatile periods or market stress.

• Trading Opportunities

  Sharp skew movements sometimes create arbitrage opportunities, where traders exploit price discrepancies between options with similar maturities but different strikes, aiming to capture mispricings.

  Understanding and applying it empowers market participants to make informed decisions, mitigate risks, capitalise on opportunities, and navigate the complex dynamics of financial markets more effectively. It is a critical tool for market analysis, option pricing, and risk management strategies, contributing significantly to trading success and portfolio performance.

Conclusion

Volatility skew is a dynamic and vital aspect of options trading, providing essential insights into market sentiment and risk perceptions. Understanding its types, calculation methods, and practical applications empowers traders and investors to navigate markets effectively. By leveraging this tool, market participants can refine strategies, manage risks, and capitalise on opportunities, underscoring its pivotal role in the intricate landscape of financial markets.