There is normally a lot of variation in Implied Volatility when comparing options in any option chain. This variation is called skew. Skew in Implied Volatility can be observed in a few different ways. When comparing the same strike price on different expirations, there is a difference in Implied Volatility. But, the skew in Implied Volatility that most traders are concerned with is the change from options with low strike prices to high strike prices. Let’s explore each type of skew and why it matters.
Term structure between different expirations
In normal situations, IV moves around more when closer to expiration than in contracts that are far out in the future. When market volatility goes up, near term options will have higher volatility than longer term options, and when market volatility is low, near term options will be lower than long term. The idea is that volatility will even out over time.
There are some exceptions to be aware of. Often, options expiring in the next few days or so will have higher Implied Volatility than those 1-3 weeks out. As options near expiration, the premium for risk takes on a bit more value than statistics might suggest.
The other exception in Implied Volatility term structure due to known future events. When there is a known event in the future- earnings report for a stock, a Federal Reserve meeting, an election, or other action where the outcome is uncertain, Implied Volatility will be higher after the timing of the event than before. When comparing premiums in different time frames, be aware of when these events are scheduled. As the events approach, Implied Volatility will likely go up unless the outcome becomes more certain. Once the event happens and the outcome is known, Implied Volatility will likely drop significantly.
Being aware of differences in Implied Volatility between different expirations can be very helpful in picking an expiration that matches the trading strategy being used. Many trading platforms show an IV index value for each expiration date that can give you a sense of the term structure of IV between various expirations at a glance.
Skew within the same expiration
More common in analysis of Implied Volatility, skew is the difference in Implied Volatility between strikes with the same expiration. Generally, there is some pattern to these differences. If the Implied Volatility values are graphed in comparison to strike prices, they usually form either a “smile” or a “smirk.”
A smile pattern of skew occurs when traders are pricing the risk of underlying prices going up to be about the same as underlying prices to go down. Strikes further from the current price have higher Implied Volatility than those close to the current price. Because these strikes are increasingly less likely to be approached, sellers require premiums with higher Implied Volatility to cover the risk of these options being breached. Only a small number of securities have a true smile pattern of skew in Implied Volatility.
A volatility smirk is where Implied Volatility is much higher either on low strike price options or higher on high strike price options. These two types of smirks are called either reverse skew or forward skew.
Options with reverse skew have higher Implied Volatility at lower strike prices. This is common most of the time in stock index options, and in the majority of stocks. This is because there is more perceived risk to the downside, so sellers require more premium for out of the money puts than for out of the money calls. As calls go further out of the money, the chance of the underlying price becomes almost non-existent, while puts far from the money still carry some risk.
Not all securities have this risk profile. Option chains with forward skew have options at higher strike prices with higher Implied Volatility. This skew is often seen in commodities, bonds, and in speculative stocks that are quickly rising in price. Forward skew happens when there is more risk of underlying prices going up rapidly than prices going down rapidly.
Changes in the slope of skew
Skew can actually be calculated and tracked for changes. The CBOE maintains a SKEW index that can be monitored on most market quoting sites. The index calculates skew as the difference between the Implied Volatility of puts and calls that are out of the money and expire in approximately 30 days, using actual prices and implied volatility from SPX expirations in the week before and after 30 days away. The calculation is quite complex, similar to how VIX is calculated. From this definition, reverse skew is positive, with out of the money puts having higher IV than out of the money calls. At this writing, the SKEW index has tracked between 1100 and 1500 in the past year. Individual stocks and other types of securities would see very different values.
Higher SKEW values are in place when the market concludes that there is less chance of a large up move in the market, perhaps concluding that the market is overbought, or close to overbought. SKEW decreases when the market makes a sudden drop, because a large up move becomes closer to the same likelihood as a large down move. But always, at least for SPX and SKEW, the option market is always skewed to price out of the money puts with higher Implied Volatility than out of the money calls.
Uses of Skew
Skew within the same expiration of an option chain can be used to pick appropriate strategy. Ideally, traders have an advantage to sell options with higher IV and buy options with lower IV. With reverse skew, premium on out of the money puts is relatively higher than out of the money call premium. Puts on indexes are priced higher for a given level of risk than calls. This extra premium helps make put selling much more successful than put buying.
Since calls on equity indexes typically have lower IV, there is not as big of an advantage to selling calls over buying. I’ve lost way more positions selling calls than selling puts. Some studies I’ve seen by tastytrade.com suggest that the average profit and loss of selling out of the money calls is about the same as buying calls. Since equity markets tend to have a slight upward bias, this makes a lot of sense, and matches my personal experience. As a result, I often sell calls as part of a call backspread to have positive upward price exposure.
However, while I use these strategies for equity index options, skew can guide me to take an opposite approach when an underlying security has forward skew.
Skew in Implied Volatility causes the amount of premium difference for a specific width of strike prices to be very different between calls and puts. Even the difference in Delta for the same spread width will be different based on the skew. For equity indexes with reverse skew this means a put spread will have a smaller difference in Delta than an equal width call spread on the same expiration. The calls will likely have more premium for the same width of spread as puts. Interestingly, premium pricing indicates that there is more risk for calls at the same Delta as a similar put. Selling an equal width Iron Condor in SPX will provide a negative Delta position because of SKEW. To have a Delta neutral position, a trader must sell a dynamic Iron Condor with strike width determined by Delta difference, not strike width difference.
Even though there are calculations possible as mentioned earlier, for me I just look at the Implied Volatility column of the option chain and see whether IV increases with strike price (forward skew) or decreases (negative skew). Occasionally, a chain will be higher on both out of the money puts and calls, with at the money IV the lowest (a skew smile). A quick look is generally enough to pick the type of skew present.
So, more than just an interesting pattern, skew tells a lot of information about direction of increased risk and premium pricing. It informs the choices I make around strategy for typical trades, and for unique situations I always look at it as part of picking strikes and strategies.
Enjoyed the read. Thank you. Very well explained