Understanding Skew: The Key to Interpreting Volatility in Options

The volatility skew represents one of the most important concepts for options traders. It refers to the variation in implied volatilities (IV) that appear across different strike prices of the same underlying asset. When these volatilities are mapped on a chart, a curve is formed that is not linear, revealing much about market expectations for future price movements.

When the volatility curve is symmetrical, it is called a volatility smile. When it shows clear asymmetry, transforming into a tilted curve, it is called a volatility smirk. This tilt is not random – it reflects how the market prices the risk of extreme movements of the asset in different directions.

Skew Structure: Time and Price Dimensions

Volatility skew can be analyzed from two fundamentally different perspectives. The first is the horizontal skew, which observes how the volatility of a given strike price varies across different expiration horizons. The second is the vertical skew, which examines the variation in volatility among different strike prices on the same expiration date.

Between these two dimensions, professional traders pay more attention to the vertical skew because it provides more immediate signals about market positioning and expectations. The vertical skew reveals important inconsistencies that can be exploited in short-term trading strategies.

The Two Main Patterns: Forward and Reversal

Skew can be classified into two main directions, each suggesting opposite market sentiments. In the forward skew, options with higher strike prices have higher implied volatilities compared to lower strikes. This pattern indicates optimism – the market estimates a higher probability of the underlying asset rising, increasing the value of call options.

The reversal skew shows the opposite: implied volatility is higher at lower strike prices. This pattern reflects fear of decline, with the market assigning greater risk to negative movements. In this scenario, put options command higher premiums. It’s important to note that in markets where short selling mechanisms are limited or costly, the reversal skew becomes the norm, as investors primarily use puts for protection.

Applying Skew in Trading Decisions

Observing and interpreting volatility skew allows traders to make more informed decisions about which strike prices to buy and which to sell, especially when constructing spread trades. The magnitude and direction of the skew act as a market sentiment thermometer.

In bullish markets, for example, traders often build bull call spreads, leveraging the volatility structure. However, when the forward skew shows limited amplitude, a lower-cost alternative strategy might be a bull put spread. Smart analysis of the skew pattern enables optimizing both risk and potential return of the trade.

Understanding these nuances of volatility skew transforms raw options price data into strategic intelligence for the trader.