Volatility skew is a pattern that reveals market sentiment about risk, which can help find trade opportunities, manage risk, or refine hedging strategies. More commonly known as options skew, it’s essentially the observed difference in implied volatility (IV) across different strike prices or expiration dates for options in the same asset.
One bizarre detail this pattern shows is that more often than not, out-of-the-money (OTM) puts tend to show higher Implied Volatility than OTM calls or at-the-money (ATM) options. While this comes as a surprise to a lot of traders, it leaves many asking what the role volatility skew plays in this correlation.
While guest hosting Wednesday’s MarketMinds episode, Mike Shorr took a deep dive into volatility skew. When he broke down why Implied Volatility gets so much higher in OTM puts than OTM calls or ATM options, Mike summed it up to two main reasons: Protection, and supply/demand.
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Mike’s summary of these two reasons highlights a number of details, including:
- Why long positions are a key driver behind higher IV in put options than calls
- How covered calls create volatility skew
- Reasons traders would want to buy insurance against any of their long positions
- Getting potential yield enhancement by selling calls or buying puts against long positions
- The big influence laws of supply and demand have in creating skew curves for option trades
If you liked Mike’s breakdown on volatility skew, check out what else he has planned…
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Mike and the Prosper team are going to Vegas…want to join them?
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