Volatility Skew

Definition

Volatility Skew, also known as options or implied volatility skew, is a financial term that indicates the discrepancy in assumed volatility for options on a single underlying asset with different strike prices. It typically represents the market’s assumption of future volatility and is often seen as a difference between out-of-the-money, at-the-money, and in-the-money options. The skew, which can either be positive or negative, allows traders to measure market sentiment and potentially predict future price movements.

Phonetic

/vɒləˈtɪlɪti skuː/

Key Takeaways

Sure, here it is:

1. Volatility Skew refers to the variation or disparity in the implied volatility of option contracts depending on the strike price. It is graphically displayed as a skew or a curve instead of having a flat or constant volatility, which the Black Scholes Model assumes.
2. The existence of Volatility Skew in the market indicates that investors are willing to pay more for options that are either out-of-the-money (OTM) or in-the-money (ITM), depending on the type of skew, compared to at-the-money (ATM) options. The shape of the volatility skew gives critical information about the market’s expectations for future price movements and market sentiment.
3. There are two types of volatility skew: the positive skew or a forward skew, where OTM calls have higher implied volatilities, and the negative skew or the reverse skew, where OTM puts have higher implied volatilities. In markets, a negative skew is more common as investors often buy OTM puts to hedge against downside risk.

Importance

Volatility skew, also known as the “options skew” or “smile,” is an essential concept in finance that helps traders, investors, and risk managers to understand and manage market risks effectively. It represents the discrepancy in implied volatility of different strike prices on an options chain for a single underlying asset. This phenomenon is important because it provides insights into market expectations of future asset price movements and reflects the market’s perceived risk of large, downside price swings. By analyzing the volatility skew, investors can exploit pricing inefficiencies in options markets and employ appropriate hedging strategies according to the perceived risk, which could enhance investment outcomes and improve risk management.

Explanation

Volatility skew is a crucial concept in options trading that investors and financial analysts use to evaluate market conditions and potential risks. The primary purpose of volatility skew is to measure the disparity in implied volatility of out-of-the-money, at-the-money, and in-the-money options. Specifically, it helps investors understand how the market perceives the likelihood of dramatic price shifts — either upward or downward. In a ‘normal’ market, out-of-the-money options usually have lower implied volatility than at-the-money options, but during periods of market instability, this relationship may invert.Volatility skew is invaluable as it offers insights into the market’s emotional state and the expected future performance of an underlying asset. By plotting the implied volatility against various strike prices, investors can visualize volatility skew and make strategic decisions. Out-of-the-money put options, for instance, might exhibit higher implied volatility during periods of extreme market fear because investors are willing to pay more for these options as a hedge against potential steep drops in the asset’s price. Thus, by understanding the implications of the volatility skew, investors can better manage their risk and optimize their investment strategies.

Examples

1. Stock Market Crash of 1987: Perhaps one of the most famous examples of extreme volatility skew occurred during the stock market crash of 1987, also known as Black Monday. On the day of the crash, there was a significant difference in implied volatility between out-of-the-money, at-the-money, and in-the-money options. Due to fear and uncertainty, investors were willing to pay more for out-of-the-money options – both puts and calls – leading to an unusual skewing.2. Airline Industry during the Covid-19 Pandemic: As lockdown measures were implemented globally in 2020, the airline industry experienced severe disruption. The uncertainty around travel restrictions and fear of decreasing demand led to a greater volatility skew in options tied to airline stocks. Traders bidding up out-of-the-money put options expected the prices of these airline stocks to drop, which increased the implied volatility skew.3. Brexit Referendum: Leading up to the United Kingdom’s Brexit referendum in 2016, the British pound experienced a significant volatility skew. Market participants were uncertain of the result and its potential impacts on the economy and the value of the pound. This resulted in a volatility skew as investors bid up out-of-the-money options to protect themselves against potential adverse currency movements.

Frequently Asked Questions(FAQ)

Related Finance Terms

• Implied Volatility
• Options Pricing
• Volatility Smile
• Black-Scholes Model
• Risk-Neutral Measure

Sources for More Information

• Investopedia
• The Options Guide
• Corporate Finance Institute
• Fidelity