Volatility Smile and Skew Explained: What Options Traders Need to Know

When you look at the implied volatility of options across different strike prices, you will notice that IV is not the same everywhere. This phenomenon creates patterns called the volatility smile and volatility skew. Understanding these patterns helps you identify mispricings and select better strikes for your trades.

What is Volatility Smile?

The volatility smile is a pattern where implied volatility is higher for options that are far out-of-the-money (both puts and calls) compared to at-the-money options. When you plot IV against strike prices, it forms a U-shape that resembles a smile.

Why Does the Smile Exist?

The volatility smile exists because the Black-Scholes model assumes stock returns follow a normal distribution. In reality:

• Markets crash more often than the model predicts (fat left tail)
• Extreme moves in both directions happen more than expected
• Traders pay extra premium for out-of-the-money protection
• Market makers charge more for options that are harder to hedge

What is Volatility Skew?

Volatility skew refers to the difference in implied volatility between puts and calls at various strike prices. In equity markets, you typically see a "put skew" where lower strike puts have higher IV than higher strike calls.

Why Put Skew Exists

Equity markets exhibit put skew for several reasons:

• Crash protection demand: Institutions buy puts to protect portfolios
• Asymmetric moves: Markets fall faster than they rise
• Leverage effect: When stocks fall, company leverage increases, making them riskier
• 1987 crash memory: After Black Monday, traders began pricing in crash risk

Smile vs Skew: Key Differences

Volatility Smile

• Both OTM puts and OTM calls have higher IV than ATM
• Creates a symmetrical U-shape
• Common in currency markets and some commodities
• Reflects equal fear of large moves in either direction

Volatility Skew

• OTM puts have higher IV than OTM calls
• Creates an asymmetrical shape (higher on the left)
• Common in equity and index options
• Reflects greater fear of downside moves

Reading the Volatility Surface

The volatility surface shows IV across all strike prices and expirations. It is a three-dimensional representation that combines smile/skew with term structure.

What to Look For

• Steep skew: Market is pricing in significant crash risk
• Flat skew: Less concern about extreme moves
• Elevated short-term IV: Near-term event causing uncertainty
• Inverted skew: Sometimes occurs in takeover situations or short squeezes

Trading Implications of Skew

For Selling Put Credit Spreads

Put skew affects your credit spread entries:

• The put you sell has higher IV than a call at equal distance
• You collect more premium on the put side
• However, the skew exists because downside risk is real
• Be aware of the risk you are taking on

For Buying Protective Puts

Skew makes downside protection expensive:

• OTM puts cost more than their call equivalents
• Consider put spreads instead of outright puts to reduce cost
• Buy protection when skew is relatively low

For Iron Condors

Skew creates asymmetry in iron condor pricing:

• The put side collects more credit than the call side
• You might adjust strike distances to balance premium
• Some traders intentionally lean toward one side based on skew

Skew Trading Strategies

Strategy 1: Selling Rich Skew

When put skew is unusually steep:

• Sell put spreads to capture the elevated premium
• Consider ratio spreads to exploit skew differences
• Be prepared for the rare but severe downside event

Strategy 2: Buying Cheap Skew

When skew is unusually flat:

• Put protection is relatively cheap
• Good time to buy portfolio hedges
• Consider put spreads or collars

Strategy 3: Skew Arbitrage

Professional traders sometimes trade skew directly:

• Risk reversals (sell put, buy call) when skew is steep
• Butterfly spreads to capture specific skew mispricings
• Calendar spreads across different expirations

How Events Affect Skew

Various market conditions change the skew pattern:

During Market Stress

• Skew typically steepens dramatically
• OTM puts become very expensive
• Reflects panic buying of downside protection

During Calm Markets

• Skew tends to flatten
• Less demand for crash protection
• Put spreads become more attractive

Around Earnings

• Skew often inverts slightly for individual stocks
• Upside calls may become expensive if traders expect positive surprise
• Both sides see elevated IV due to event uncertainty

Measuring Skew

Several methods quantify skew:

25 Delta Skew

Compares IV of 25 delta put to 25 delta call:

• Positive skew: Put IV > Call IV (normal for equities)
• Negative skew: Call IV > Put IV (rare, often around events)

Skew Index (SKEW)

The CBOE publishes a SKEW index measuring tail risk in S&P 500 options. Higher values indicate greater concern about extreme moves.

Common Mistakes with Skew

• Ignoring skew in strategy selection: Not all strikes are priced equally
• Fighting extreme skew: Steep skew exists for a reason - do not assume it will normalize quickly
• Comparing different underlyings: Normal skew varies by asset class and security
• Forgetting about gamma risk: High IV OTM options have different risk profiles

Summary

Volatility smile and skew describe how implied volatility varies across strike prices. In equity markets, puts typically have higher IV than calls at similar distances from the current price. This skew reflects the market's fear of downside crashes and affects how you should price and trade options strategies. Understanding skew helps you identify relatively cheap or expensive options and structure better trades.

Want to learn more about volatility? Check out our guide on implied vs historical volatility or learn about volatility indicators you can use in your trading.