Volatility skew is one of the most powerful but least understood concepts in options trading. It reveals what the market really fears, shows you which options are relatively cheap or expensive, and opens up unique trading opportunities. This guide will teach you how to read and trade volatility skew.
What is Volatility Skew?
Volatility skew refers to the pattern of implied volatility across different strike prices for options with the same expiration date. In a perfect theoretical world, all strikes would have the same IV. In reality, different strikes have different IVs, and this difference is the skew.
Simple explanation: Out-of-the-money puts usually have higher IV than at-the-money options, and out-of-the-money calls usually have lower IV. This creates a "skewed" pattern when you plot IV against strike price.
Why Does Volatility Skew Exist?
The skew exists because of supply and demand for options at different strikes. There are several key reasons:
- Crash protection demand: Investors buy puts to protect their portfolios, driving up put prices and IV
- Covered call selling: Many investors sell calls against their stock positions, adding supply and lowering call IV
- Fat tail risk: Markets tend to crash faster than they rally, making downside protection more valuable
- Leverage effects: When stocks drop, volatility increases, making puts more valuable
Types of Volatility Skew
1. Put Skew (Reverse Skew)
The most common pattern, especially in equity markets. Lower strikes have higher IV than higher strikes. This is sometimes called "normal" skew because it is so prevalent.
Put Skew Example
Stock trading at $100:
- $80 put: 45% IV
- $90 put: 38% IV
- $100 put (ATM): 32% IV
- $110 call: 28% IV
- $120 call: 25% IV
The downside puts have significantly higher IV than upside calls, showing the market's fear of downside moves.
2. Call Skew (Forward Skew)
Less common, but appears in commodities and during squeeze situations. Higher strikes have higher IV than lower strikes.
3. Volatility Smile
When both deep OTM puts and deep OTM calls have elevated IV compared to ATM options. Common in currencies and around major events like earnings.
How to Measure and Read Skew
There are several ways to quantify skew:
- 25 Delta Skew: Difference between 25 delta put IV and 25 delta call IV
- Put/Call IV Ratio: OTM put IV divided by OTM call IV
- Skew Index: Some platforms calculate a proprietary skew measure
Interpreting skew: When put skew is higher than normal, the market is particularly fearful of downside. When skew flattens or reverses, it often signals complacency or bullish sentiment.
Trading Strategies Using Skew
Strategy 1: Sell Expensive Puts, Buy Cheap Calls
When put skew is elevated, OTM puts are relatively expensive. You can sell put spreads and buy call spreads to take advantage of this pricing difference.
Skew Arbitrage Example
Stock at $100 with elevated put skew:
- Sell the $95/$90 put spread for $1.50 (selling expensive put IV)
- Buy the $105/$110 call spread for $1.00 (buying cheap call IV)
- Net credit: $0.50
This trade profits if the stock stays flat, goes up, or even drops slightly. You are being paid for taking on downside risk that the market overprices.
Strategy 2: Risk Reversal
Sell an OTM put and use the premium to buy an OTM call. This exploits skew while creating a bullish position with little or no upfront cost.
Strategy 3: Put Ratio Spreads
Sell more OTM puts than you buy, capturing the elevated IV of the further OTM options. Use this when put skew is extreme.
Strategy 4: Skew-Adjusted Vertical Spreads
When selling vertical spreads, choose strikes where the skew works in your favor. Sell the higher IV strike and buy the lower IV strike.
Reading Skew Changes for Market Signals
Changes in skew can signal shifts in market sentiment:
- Skew increasing: Growing fear of downside, often before corrections
- Skew decreasing: Complacency building, sometimes precedes volatility spikes
- Skew inversion: Extremely bullish sentiment, call buyers driving up call IV
- Skew normalization: Return to normal levels after extreme moves
Real-World Skew Signals
Before the 2020 COVID crash, put skew was historically low - the market was complacent. As the crash unfolded, put skew spiked to extreme levels as everyone rushed to buy puts. Traders who watched skew had early warning signs.
Skew in Different Markets
Skew behaves differently across asset classes:
- Equity indices (SPY, QQQ): Strong put skew due to institutional hedging
- Individual stocks: Variable skew, higher around earnings
- Commodities: Often call skew due to supply disruption fears
- Currencies: Typically symmetric smile pattern
- Meme stocks: Can have inverted skew during squeeze events
Common Skew Trading Mistakes
- Ignoring the reason for skew: Skew exists for a reason; do not assume it is always wrong
- Oversizing skew trades: These are edge trades, not home run swings
- Not hedging properly: Skew trades often have undefined risk on one side
- Forgetting about earnings: Skew behaves differently around events
- Trading illiquid strikes: Deep OTM options have wide spreads that eat your edge
Building a Skew Trading System
Here is how to systematically incorporate skew into your trading:
- Monitor skew levels: Track 25 delta skew for your regular trades
- Compare to historical norms: Is skew high or low compared to its own history?
- Identify extremes: Look for skew at the top or bottom of its range
- Choose appropriate strategies: Sell expensive side, buy cheap side
- Manage position size: Skew trades should be a small part of your portfolio
Visualize Volatility Skew Instantly
Pro Trader Dashboard displays volatility skew across strikes, helping you identify when puts or calls are relatively expensive. Find skew trading opportunities with ease.
Summary
Volatility skew reveals the market's fear and greed across different strike prices. Put skew is usually elevated due to demand for crash protection, creating opportunities to sell expensive puts and buy cheap calls. Watch skew changes for market signals, and use skew-aware strategies to improve your trading edge. Remember that skew exists for real reasons, so trade it with respect and proper risk management.
Continue learning with our guide on the volatility smile or explore term structure trading.