Delta skew in currency markets is the difference in pricing between call options (bets on a rise) and put options (bets on a fall) of a currency pair.

When this pricing is uneven, it creates an imbalance, which traders call a skew. It helps traders see if the market is more fearful of downside risks or upside potential.

Delta measures how much the price of an option moves in response to changes in the price of the already-existent asset.

 For example, if a forex option has a delta of 0.5, the option price is expected to move $0.50 for every $1 move in the currency pair.

Skew refers to the uneven pricing of options. It shows how the implied volatility of options changes with different strike prices.

How to Measure Delta Skew in Currency Markets

1. Identify the Delta Values: Find the delta values of both call and put options for a particular strike price and expiration date.

2. Find the Difference: Subtract the delta of the put option from the delta of the call option. This difference represents the delta skew.

3. Interpret the Value: A positive delta skew suggests that call options are priced higher relative to puts, indicating bullish sentiment. A negative delta skew indicates higher-priced puts, reflecting bearish sentiment.

The formula for Determining Delta Skew:

Delta Skew = Delta of Call Option – Delta of Put Option

For example, if a call option has a delta of 0.6 and a put option has a delta of -0.4, the delta skew would be 0.6 – (-0.4) = 1.0.

Software and Platforms to Measure Delta Skew in Real-Time

Platforms like Bloomberg and Reuters: These financial platforms offer real-time options data, including delta values, making it easier to monitor delta skew.

Specialized Forex Trading Software: Some platforms provide delta skew analysis tools specifically for forex options, allowing traders to quickly visualize skew changes.

Examples with Calculations Using Forex Options Data:

Suppose a trader is analyzing EUR/USD options. The delta of a call option at a certain strike is 0.65, while the delta of a put option at the same strike is -0.35.

Calculation: Delta Skew = 0.65 – (-0.35) = 1.0.

This positive delta skew shows that the market is more inclined towards bullish movements in EUR/USD because calls are more expensive than puts.

How to Interpret Delta Skew Charts

Delta skew charts plot the difference in the delta between calls and put over time or across various strike prices.

1. Positive Delta Skew: Indicates that traders are paying more for call options, possibly signalling a bullish market outlook.

2. Negative Delta Skew: Shows a preference for put options, suggesting that traders are worried about a downward movement in the currency pair.

N/B: Charts can display the delta skew for pairs like EUR/USD, GBP/USD, and USD/JPY.

When you compare delta skew curves for different currency pairs, you can see where market sentiment varies, such as which currency pairs are perceived as riskier.

Examples of Typical Delta Skew Shapes

Positively Skewed: The curve tilts upwards, showing that calls are in greater demand.

Negatively Skewed: The curve tilts downwards, indicating that puts are being priced higher.

Neutral Skew: A flat or nearly flat curve, showing balanced pricing between calls and puts.

Why it is Important to Understand Delta Skew in the Currency Market 

1. Gives you an understanding of Market Sentiment

Delta Skew gives a clue of how you should feel about the future of a currency. A large skew shows that you should expect big movements in one direction.

2. Evaluating Risk in the Market

When you use delta skew, you can better assess what risks the market is pricing in. For example, if the skew is steep, it could mean that you should be preparing for more uncertainty or risk in the market.

3. Relevant Market Conditions

Delta skew is especially important during uncertain times, like geopolitical events (e.g., elections, trade disputes) or when central banks make big announcements (e.g., interest rate changes).

During these times, skews can become more pronounced as traders rush to hedge their positions.

What is Delta?

Delta measures how sensitive an option’s price is to changes in the price of the currency pair. It helps traders understand how much their option’s value will change if the underlying currency moves.

Delta ranges from 0 to 1 for call options (bets that the price will rise) and from 0 to -1 for put options (bets that the price will fall). For example, a delta of 0.7 means the option will change by $0.70 for every $1 move in the currency.

Delta can also show the chance of an option expiring with value. A call option with a delta of 0.6 has roughly a 60% chance of expiring with value.

Traders use software or option-pricing models to calculate delta, making it easier to understand how sensitive their options are to currency price changes.

What is Option Skew?

Volatility Skew or Smile: Skew shows how the implied volatility (expected future movements) changes for different option strike prices. 

Sometimes it’s called a “volatility smile” when plotted on a graph, showing that out-of-the-money options (those far from the current price) can be more expensive due to higher demand.

Implied Volatility for OTM Calls and Puts: Implied volatility is often different for calls and puts that are far from the current price of the currency pair.

This difference shows where traders are more focused—whether they are protecting against big drops (buying puts) or big rises (buying calls).

Demand for Hedging: Skew shows where there is more demand for protection, like when traders want to guard against a fall in a currency. If more traders buy puts to protect against drops, the skew tilts, showing a higher price for those options.

Delta Skew vs. Volatility Skew

Delta skew focuses on how the delta of calls and puts differ, while volatility skew is more about the differences in implied volatility at various strike prices.

Delta skew tells you about option sensitivities, while volatility skew tells you about market expectations for big moves.

Delta skew is more about the difference in options’ delta values, which helps traders assess price sensitivity.

 Volatility skew, on the other hand, is about how much traders think a currency might swing.

Delta skew might show a sudden shift in market sentiment that isn’t obvious in volatility skew, like when traders suddenly shift their hedging from one direction to another without a big change in overall volatility. 

Factors Influencing Delta Skew in Currency Markets

1. Impact of Fear or Optimism

Traders’ emotions, such as fear or optimism, can greatly influence delta skew. For example, if investors are nervous about a possible downturn, they may buy more put options, which can make the delta skew negative.

Conversely, optimism about a currency’s rise can lead to higher demand for call options, pushing the delta skew in a positive direction.

2. Influence of Geopolitical Events, Economic Data, and Central Bank Policies:

Major events, such as geopolitical tensions, economic data releases, or shifts in central bank policies, can trigger changes in delta skew. These events alter market expectations, influencing how traders hedge with options.

During the COVID-19 pandemic, uncertainty drove demand for put options across various currencies, resulting in a negative delta skew.

Central bank policy shifts, like aggressive interest rate hikes by the Federal Reserve, can lead to increased call option buying on USD pairs, creating a positive delta skew.

3. Supply and Demand for Options

When more traders buy call options, the delta of those calls increases, which can create a positive delta skew. But, high demand for put options pushes the delta skew into negative territory.

4. Impact of Institutional Traders’ Strategies

Large institutional players, such as hedge funds, often use options to hedge their positions. For example, in a market downturn, they might buy protective puts in large volumes, leading to a more pronounced negative delta skew.

During stock market downturns or economic uncertainty, institutional investors might buy puts on USD/JPY to hedge against risk-off movements, leading to an increase in negative delta skew.

5. Implied Volatility Movements

Implied volatility (IV) represents market expectations of future price movements. As IV rises, especially for out-of-the-money puts, it can increase the delta of those options, which might result in a negative delta skew. However, when the IV rises more for calls, it can create a positive skew.

6. Impact of Increasing Volatility

Higher overall volatility can make delta skew more pronounced, as traders become more willing to pay a premium for options to hedge against large price movements.

7. Analysis of High Volatility Periods

During economic crises, like the 2008 financial crisis, the delta skew often shifts as fear pushes traders to buy protective puts, resulting in a negative skew.

How Interest Rate Changes Affect Delta Skew in Currency Markets

Interest rates between two currencies can influence delta skew. For example, if one central bank raises rates while another keeps them low, the higher-yielding currency might see more demand for call options and this affects the delta skew positively.

Impact of Carry Trades

Traders engaged in carry trades (borrowing in a low-interest currency to invest in a high-interest one) often use options to hedge. This hedging activity can influence delta skew, especially if interest rates change or if traders anticipate shifts in rates.

Example:

When the Federal Reserve raises interest rates, it often leads to increased demand for USD call options, potentially resulting in a positive delta skew.

Similarly, if the European Central Bank signals a rate cut, traders might buy more EUR put options, leading to a negative delta skew for EUR/USD.

Practical Applications of Delta Skew in Forex Trading

1. Hedging Strategies

Traders use delta skew data to design hedging strategies with forex options. When the skew is properly analyzed, they can determine whether to buy more puts or call for effective protection against potential price drops.

When a trader anticipates a significant risk in a currency pair, they can use delta skew information to select the right option strategy to minimize losses.

For instance, if the skew suggests a higher likelihood of a price decline, traders may opt for more put options to hedge.

Suppose the delta skew indicates that puts are in high demand, suggesting market fear.

A trader could use this insight to construct a protective collar strategy by buying put options for downside protection while selling call options to offset the cost.

2. Arbitrage Opportunities

Finding Price Imbalances: Delta skew differences between similar options can create arbitrage opportunities.

Traders can exploit these by purchasing options that are undervalued and selling those that are overvalued. This will make them profit from the price adjustment as the market balances out.

Example of Arbitrage: If a trader notices that the delta skew for EUR/USD options is higher than similar GBP/USD options, they could buy the undervalued GBP/USD options while selling the overvalued EUR/USD options.

3. Strategies for Skewed Markets

In markets with pronounced skew, traders use strategies like skew trades. This involves buying options on the side that show lower demand (cheaper options) and selling options where demand is higher (more expensive options).

This strategy allows traders to balance risk by hedging their positions based on demand differentials in the options market.

Example – Trading Setup Using Delta Skew:

Bullish Strategy: If the EUR/USD delta skew suggests a high demand for EUR call options (indicating a positive skew), a trader may anticipate upward price movement. They might choose to buy EUR/USD during a dip, expecting further buying pressure.

Bearish Strategy: If the skew tilts heavily towards puts, suggesting market concern, the trader may look for a bearish setup, like shorting EUR/USD, expecting downward movement.

Challenges in Using Delta Skew

1. Complexity of Calculations

Calculating delta skew accurately can be complex without advanced tools. It often requires deep understanding and access to complex formulas and data feeds.

Since delta skew can change quickly with market conditions, having access to real-time data is essential to accurately monitor and interpret changes.

Traders can simplify the process using platforms like Bloomberg, Reuters, or specific trading platforms.

2. Market Illiquidity and Its Impact on Skew

Low market liquidity can skew delta readings, making it harder to interpret. Illiquid conditions can cause option prices to be more erratic, distorting delta skew.

During periods like holidays or weekends when trading volume is low, delta skew readings can become less reliable as a market indicator.

Traders should be cautious about using delta skew during these periods. They should consider the broader market context to avoid being misled by abnormal skew patterns.

3. Misinterpretation of Delta Skew Signals

Traders might misinterpret delta skew signals, especially if they rely solely on skew without considering other indicators. For example, assuming that a positive skew always means bullish sentiment can be misleading.

Depending too much on delta skew without using other technical or fundamental analyses can lead to poor trading decisions.

It’s important to combine delta skew analysis with other indicators like volume, trend analysis, and macroeconomic factors to form a trading strategy.

Delta Skew Behavior in Popular Currency Pairs

EUR/USD: This pair often shows a balanced skew in stable market conditions. During times of uncertainty, the skew may shift towards puts, indicating market fear.

USD/JPY: The Bank of Japan’s monetary policy decisions can have a significant impact on the delta skew for this pair.

For example, a shift in interest rate policy might cause a rapid change in demand for calls versus puts.

GBP/USD: During Brexit negotiations, the delta skew in GBP/USD options was highly volatile, reflecting traders’ attempts to hedge against unexpected political outcomes. The skew often shifted towards puts as uncertainty increased, signalling caution in the market.