If you have been trading in the Forward and Options market, you will know that volatility is a major component that decides the premium price of various options.
However, before we understand what a volatility skew is, it’s good to have an idea of implied volatility and how it affects the markets.
What is Implied Volatility?
Implied volatility is the measure of uncertainty and fear that prevails in the market. A higher implied volatility, means the option prices will be higher. So, naturally when the market is falling, especially in gaps -Implied volatility is high and when the market is still or moves up - the implied volatility is low.
In certain situations like Elections, RBI policy announcements or stock result announcements, the Implied volatility goes up before the event which ends up increasing the option prices.
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In options pricing, it is generally assumed that options with the same underlying asset and expiration date should have similar implied volatility. However, market participants often price downside options higher, reflecting concerns over greater potential volatility on the downside compared to the upside.
What is Volatility Skew?
Volatility skew represents the disparity in implied volatility between at-the-money (ATM), in-the-money (ITM), and out-of-the-money (OTM) options. This variance forms patterns, typically resembling a "smile" or "smirk," when plotted on a graph, depending on whether the implied volatility tilts in favour of OTM or ITM options.
A balanced curve, referred to as a "volatility smile," indicates symmetrical volatility for both OTM and ITM options. In contrast, a tilted curve known as a "volatility smirk," signals an imbalance, often with higher volatility on one side.
What Does Volatility Skew Tell Investors?
Here are some key interpretations of volatility skew:
● Positive or Forward Skew
A positive skew occurs when OTM call options have higher implied volatility than OTM put options. A positive skew indicates that the market is anticipating upward price movement.
● Negative or Reverse Skew
A negative skew arises when OTM put options have higher implied volatility than OTM call options. This is common in equity markets, where investors are more worried about price declines and are willing to pay a premium for put options as protection.
A negative skew signals that the market expects a downward price trend.
● Volatility Smile
A "smile" occurs when both OTM call and put options have higher implied volatility compared to ATM options. This shape often appears in markets facing high uncertainty, where significant price fluctuations in either direction are expected.
● Flat or No Skew
When there is no skew, implied volatility remains consistent across all strike prices. This suggests that the market does not anticipate any major price swings, and no significant upward or downward movement is expected.
Let’s assume a trader is evaluating options for a particular stock. If OTM puts (downside protection) show higher implied volatility compared to OTM calls (upside speculation), it signals that investors anticipate more volatility on the downside.
This "skew" reflects concerns about a potential price drop, and you can adjust your strategy accordingly.
The Role of Volatility Skew in Market Sentiment
Volatility skew is a powerful indicator of how the market perceives risk and uncertainty.
When the skew is more pronounced, it suggests heightened concern for downside risk, as investors are willing to pay more for protection.
A flatter skew indicates balanced sentiment with no particular focus on downside volatility.
By closely monitoring volatility skew, investors can gain insights into the broader market sentiment, and they can adjust their strategies for buying or selling options contracts.
Conclusion
Volatility skew is a key tool for options traders that offers insight into market sentiment and the pricing of options contracts. By understanding how to measure volatility skew, you can make an informed decision that aligns with the market conditions.
Volatility skew does offer valuable information but options trading comes with a very high risk, and it's best suited for experienced traders. If you are new to options trading, it's better to seek guidance from a financial professional before diving into this complex area of options trading.
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