Understanding Volatility Skew

What is Volatility Skew?

We have seen that Implied Volatility can differ across Strike Prices.

However, the difference is not always symmetrical between Calls and Puts.

When the IV of options changes depending on the Strike Price, creating a noticeable difference between the two sides of the option chain, it is referred to as Volatility Skew.

In simple terms:

Volatility Skew = Difference in Implied Volatility across different Strike Prices or option types.

Why Does Skew Exist?

The market does not assign the same probability or risk to every possible price movement.

For example, traders may be more concerned about a sharp fall in an underlying than a sharp rise.

In such a situation, OTM Put Options may attract greater demand.

Higher demand for these Puts can push their premiums higher.

Since option premiums are linked to Implied Volatility, their IV can also become higher than that of comparable Calls.

This creates a skew.

Put Skew

One common form of skew occurs when OTM Put Options have higher IV than comparable OTM Call Options.

This can happen because investors may be willing to pay more for downside protection.

For example, consider an underlying trading at ₹10,000.

Suppose:

• 9,500 Put IV = 28%
• 10,500 Call IV = 22%

The Put has higher implied volatility.

This indicates that the market is pricing greater volatility or demand for protection on the downside.

Why Are OTM Puts Important?

Institutional investors and other market participants often use Put Options to protect portfolios against sharp declines.

When demand for downside protection increases:

Put Demand ↑

Put Premium ↑

Put IV ↑

This can make OTM Puts appear more expensive relative to OTM Calls.

Skew Can Change Over Time

Volatility skew is not permanent.

It can change depending on:

• Market conditions
• Investor sentiment
• Demand for protection
• Major events
• Fear or uncertainty
• Changes in supply and demand for different options

During calm market conditions, the difference between Put and Call IV may be relatively small.

During periods of stress, downside Put IV can rise sharply.

Understanding Skew Through the Option Chain

Imagine the following simplified option chain:

The Put IV is higher at several strikes.

This tells us that the market is assigning relatively greater volatility to downside options.

The exact interpretation depends on the underlying and market conditions.

Skew vs Volatility Smile

These two concepts are related but not identical.

Volatility Smile

IV forms a roughly symmetrical smile across Strike Prices.

Volatility Skew

IV is noticeably different across strikes, with one side of the distribution having higher IV than the other.

In real markets, volatility curves may not form a perfect smile.

They can be tilted or distorted depending on market demand and risk.

Why Skew Matters to Traders

Skew provides information about how volatility is distributed across Strike Prices.

Suppose two options have similar expiry and similar distance from the current price.

If one has significantly higher IV, it may indicate:

• Greater demand for that option
• Greater perceived risk
• Higher willingness to pay for protection
• Different expectations about potential price movements

This can be useful when comparing option strategies.

Skew and Option Strategies

Consider an option seller comparing two OTM options.

One has significantly higher IV than the other.

The higher IV option may offer a larger premium.

But that higher premium may exist because the market considers that side of the risk more significant.

Therefore:

Higher IV → Higher Premium

does not automatically mean:

Higher IV → Better Trade

The additional premium may simply compensate for additional perceived risk.

Practical Insight

When analysing an option chain, do not look only at the absolute IV.

Compare:

• IV across nearby strikes
• Call IV vs Put IV
• IV across different expiries
• Current skew vs historical skew

This can reveal how the market is pricing different types of risk.

Common Beginner Mistake

A common mistake is assuming that the option with the highest IV is automatically overpriced.

High IV can reflect genuine market demand or higher perceived risk.

Before calling an option expensive, compare its IV with:

• Similar strikes
• Similar expiries
• Historical volatility
• Current market conditions

Key Insight

Volatility Skew shows that the market does not price volatility equally across all Strike Prices.

It can provide useful information about where traders are willing to pay more for protection or exposure.

Key Takeaways

• Volatility Skew refers to differences in IV across Strike Prices or option types.
• OTM Puts can sometimes have higher IV than comparable OTM Calls.
• Strong demand for downside protection can increase Put premiums and IV.
• Skew can change with market conditions and investor sentiment.
• Volatility Smile and Volatility Skew are related but different concepts.
• A skewed volatility curve indicates that different parts of the option chain carry different volatility pricing.
• Higher IV generally means a higher option premium.
• Higher IV does not automatically mean an option is overpriced.
• Traders should compare IV across strikes, expiries and historical levels.
• Skew can provide insight into how the market is pricing different risks.