Volatility Skew

What Is Volatility Skew?

Volatility skew is the pattern where out-of-the-money put options consistently trade at higher implied volatility than OTM call options at the same distance from current price. On a volatility surface, this appears as a slope or “smirk” across strikes — IV is highest on the left (low strikes, OTM puts) and falls moving right toward higher strikes (OTM calls).

Before the 1987 crash, the volatility surface for equity options was relatively symmetric — Black-Scholes was a reasonable approximation. After the crash, the market repriced the risk of sharp, sudden downside moves. Put skew became a permanent feature, reflecting two structural realities: investors systematically demand downside protection, and large crashes have historically been faster and more severe than large rallies.

Skew is measured several ways. Most common is the 25-delta skew: the IV difference between the 25-delta put and 25-delta call at the same expiration. A skew of 5 points means OTM puts are priced 5 IV points higher than equidistant OTM calls. Steeper skew reflects greater fear; flatter skew suggests complacency or reduced protection demand.

Why It Matters for Options Traders

Skew directly affects how traders price and structure trades. Any strategy involving selling puts or buying calls is implicitly a skew trade — you’re selling the expensive wing (puts) or buying the cheap wing (calls). Understanding whether current skew is elevated or compressed relative to historical norms informs trade attractiveness.

Risk reversals — simultaneously buying a call and selling a put at equidistant strikes — are pure skew trades. In normal skew conditions, risk reversals have negative premium: you collect cash selling expensive puts and buying cheap calls. In low-skew environments, risk reversals become cheaper (or even cost money), reflecting less fear of downside.

Skew affects delta calculations. Because OTM puts carry higher IV, their delta as implied by the market differs from model delta calculated assuming flat IV. This “sticky strike” vs. “sticky delta” debate matters for hedging: a move in the underlying shifts where you are on the skew curve, potentially changing effective delta in ways a simple model wouldn’t predict. Dealers managing large put books must account for the interaction between skew and vanna when hedges respond to volatility changes.

Key Characteristics

• Puts more expensive than calls: Equidistant OTM puts carry higher IV than OTM calls in most equity markets
• Post-1987 structural feature: Emerged as permanent after the 1987 crash, reflecting the market’s repricing of tail risk
• Measured via 25-delta skew: IV difference between 25-delta put and 25-delta call is the most common quantitative measure
• Risk reversal pricing: Selling puts and buying calls (risk reversal) generates credit in normal skew markets — credit size reflects skew magnitude
• Fear gauge: Steepening skew signals rising protection demand and often precedes or accompanies stress; flattening suggests complacency
• Vanna interaction: Skew creates vanna asymmetry — put-side vanna is larger than call-side, making markets more sensitive to downside IV changes