Options skew refers to the pattern where implied volatilities of options with different strike prices are not consistent, even for options on the same underlying asset with the same expiration date.
Normal vs. Skewed Volatility Surface
In a normal (or flat) volatility surface, the implied volatility is assumed to be constant across all strike prices for a given expiration date.
However, in reality, implied volatilities often vary, creating a “skew” or “smile” shape when plotted against the strike prices.
Types of Options Skew
1. Volatility Smile
- In a volatility smile, implied volatilities are higher for options with strike prices significantly above (deep out-of-the-money calls or deep in-the-money puts) or below (deep in-the-money calls or deep out-of-the-money puts) the current underlying asset price.
- At-the-money options typically have lower implied volatilities compared to deep in-the-money or out-of-the-money options.
2. Volatility Skew
- In a volatility skew, implied volatilities are higher for either in-the-money options (low strike calls or high strike puts) or out-of-the-money options (high strike calls or low strike puts), but not both.
- This creates an asymmetric or skewed volatility surface.
Causes of Options Skew
Options skew arises due to several factors:
- Market Participants’ Expectations: Expectations of future price movements and the potential for extreme events or jumps in the underlying asset’s price.
- Supply and Demand Dynamics: Influenced by hedging activities, speculative trading, and market makers’ risk management strategies.