Options skew refers to the phenomenon where options with the same expiration date but different strike prices have varying implied volatilities (IV).

This difference in IV reveals market sentiment, risk perception, and demand for options at specific strike prices.

Knowing options skew is very good for traders seeking to make informed decisions about pricing, hedging, and speculative strategies.

What is Options Skew?

Options skew, also known as volatility skew, arises when implied volatility is not uniform across strike prices or expiration dates. Instead of a flat curve, the IV often exhibits a slope or curve, indicating variations in demand and perceived risk.

Components

1. Implied Volatility (IV)

A measure of the market’s expectations for future price volatility, derived from options prices. Higher IV leads to more expensive options.

2. Strike Price

The price at which the holder of an option can buy (call) or sell (put) the underlying asset.

3. Volatility Skew Patterns

The shape of the IV curve, which may include:

Vertical Skew: Differences in IV across strike prices.

Horizontal Skew (Term Structure): Differences in IV across expiration dates.

Types of Volatility Skew

1. Smile Skew

• Implied volatility is higher for both out-of-the-money (OTM) and in-the-money (ITM) options compared to at-the-money (ATM) options.
• Common in markets where extreme price movements are expected, such as commodities or cryptocurrencies.
• Shape: U-shaped curve.

2. Smirk or Reverse Skew

• Implied volatility is higher for OTM puts than OTM calls.
• Frequently seen in equity markets, reflecting demand for downside protection.
• Shape: Downward slope as strike prices increase.

3. Flat Skew

• Implied volatility is relatively consistent across strike prices.
• Indicates balanced sentiment and low demand for specific strikes.

Causes of Options Skew

1. Market Sentiment

High demand for puts or calls at certain strike prices drives up implied volatility.

Bearish markets often show higher IV for OTM puts (fear-driven demand).

2. Supply and Demand Dynamics

Greater demand for downside protection or speculative upside drives skew patterns.

3. Historical Volatility Trends

Past price movements influence traders’ expectations of future risks.

4. Market Events

Earnings reports, geopolitical tensions, or economic data releases can create skew due to anticipated price swings.

Practical Applications of Options Skew

1. Risk Management

Skew analysis helps identify areas of concentrated risk, such as strike prices where investors are hedging against large moves.

2. Hedging Strategies

Traders can use skew to select optimal strike prices for hedging portfolios.

3. Speculative Opportunities

Skew patterns may signal market mispricing, offering arbitrage opportunities.

4. Volatility Trading

Skew provides clues about expected volatility shifts, enabling traders to exploit changes in IV.

Interpretation of Options Skew

1. Equity Markets

• Observed Skew: OTM puts exhibit higher IV than OTM calls.
• Reason: Investors prioritize protection against sudden downturns, driving up put demand.

2. Commodity Markets

• Observed Skew: A symmetric smile skew.
• Reason: Supply disruptions and price spikes lead to higher demand for both calls and puts.

3. Pre-Earnings Announcements

• Observed Skew: Elevated IV for ATM options.
• Reason: Anticipation of significant price movement post-announcement.

Example of Options Skew

1. Stock XYZ

Current price: $100

Expiration: 1 month

IV Observations:

$90 put: 40% IV (higher demand for protection)

$100 ATM call: 25% IV

$110 call: 30% IV (speculative demand for upside)

Implication: Traders expect a greater chance of downside risk but also consider a possibility of an upside breakout.

Strategies Leveraging Options Skew

1. Skew Arbitrage

Exploit mispricing between implied volatility at different strikes by combining long and short options positions.

2. Skew-Based Hedging

Use OTM options with elevated IV to protect against market moves, adjusting position sizes based on skew analysis.

3. Iron Condor/Butterfly Spreads

Use skew to set up spreads that capitalize on expected volatility or lack thereof.

4. Directional Bias Confirmation

Analyze skew to confirm market sentiment, aligning trades with dominant risk perceptions.

Limitations of Options Skew

1. Complexity

Requires advanced tools and understanding to interpret accurately.

2. Changing Nature

Skew patterns shift frequently, making it challenging to rely on them for long-term strategies.

3. Dependence on Market Conditions

Skew may not provide clear signals during low-volatility or sideways markets.

Conclusion

Options skew offers a wealth of information about market sentiment, risk perception, and potential price movements.

When you are able to analyze skew patterns, you can get to find out opportunities, refine hedging strategies, and align with market movements.

However, it is essential to pair skew analysis with other indicators and market knowledge for robust decision-making.