What is volatility skew?

Options prices or premiums are a very good gauge used by investors to determine a pending change in a market’s direction.  Not only will the price of an at the money option become more expensive as traders speculate on a direction of an underlying asset, but, out of the money options on these assets will garner a greater premium.  Understanding why a strike might have a greater volatility, relative to the at the money strikes is a crucial part of trading options.   The change in volatility between strikes is referred to as the skew.

An in the money option, is an option where the strike price of the option is equal to the current underlying price of an asset.  If crude oil were trading at 80 dollar per barrel, the 80-dollar calls and the 80-dollar puts for any time horizon are in the money.  Strike prices that are below or above 80 dollars are out of the money strikes.  When discussing strike prices that are out of the money, traders refer to the percent away from the in the money strike to designate the option.  When a trader refers to a put option on crude oil that is 10% out of the money, when crude oil is trading at $80 dollars per barrel the trader is referring to puts with a strike of $72 dollar per barrel and call options with strike at $88 dollars per barrel.

Theoretically, all options for a financial asset should trade with the same measure of volatility and at the money calls and puts with the same strike and expiration should have the same price. In practice, the demand for individual option contracts can drive up the price of some of the options on a financial instrument, which can create a disparity in prices.

There are two types of skew, strike skew and time skew. Strike skew is the measure of the disparity of option volatility for option contracts with different strikes but the same expiration. For example, a put option on crude oil that is 10% out of the money will have a higher implied volatility potentially, than a put option that is 5% out of the money. Time skew is a measure of the disparity of option volatility for option contracts with the same price but different expirations.  This means that a crude oil put option that is 10% out of the money but expires in 60 days, has a greater implied volatility than a crude oil put option that expires in 30 days.  When out of the money puts and out of the money calls both have higher implied volatility that at the money options, the implied volatility curve is said to have a smile.    When either the puts or the calls are higher or lower, the term used to designate the difference is the skew

A second type of skew is a time skew.  An example would be in examining of implied volatility for the September 70 dollar put options on crude oil and comparing them with the December 70 dollar put options on crude oil.  The implied volatility used for each option can be different, for a number of reasons.  First, the change of the underlying asset might be different (this would occur for futures contracts that have different underlying assets).  The second is that there might be more events that can take place within a longer period of time.  A third issue would be that implied volatility works have an inverse relationship with time.  Generally, if an option price where to remain constant, as time increases, implied volatility decreases.

Traditional option pricing models tend to price out of the money options lower than near the money options. As a result, computing volatility from the current price of options results in inflated volatilities as options become deeper in or out of the money, which results in the skew chart taking on a smile like curve.  In reality, as the fear of a quick movement in an underlying asset grips a trading community, out of the money options prices become more in demand and the implied volatility that is used to price these options increases.  For example, as the financial crisis started to percolate, traders wanted to protect themselves by purchasing put options that protected their portfolios from a large downward move in the equity markets.  This created a demand for both in the money and out of the money options.  The prices of out of the money options were cheaper, and therefore the demand grew pushing the implied volatility higher creating a large skew for S&P 500 opitons.

There is a particular point through the implied volatility curve where the skew or the smile begins to flatten.  It is at these inflection points that traders can take advantage or inefficiencies within the market.