Volatility skew, also known as volatility smile, refers to the pattern of implied volatility across options with different strike prices but the same expiration date. The skew represents the difference in implied volatility (IV) between out-of-the-money (OTM) options, at-the-money (ATM) options, and in-the-money (ITM) options.
The Concept of Implied Volatility
In financial markets, implied volatility (IV) is a metric used to gauge market expectations of future volatility of the underlying asset. It is derived from the market prices of options. Higher IV suggests greater expected volatility, while lower IV indicates less expected volatility.
Types of Volatility Skew
- Regular Skew: Implied volatility increases as the strike price decreases (typically seen in equity markets).
- Reverse Skew: Implied volatility increases as the strike price increases (often observed in commodities markets).
- Humped Skew: Implied volatility is lower for both ITM and OTM options compared to ATM options.
Significance of Volatility Skew
Market Sentiment
Volatility skew is a powerful indicator of market sentiment. For example:
- Positive Skew (Regular Skew): Higher IV for OTM puts may signal investor concerns about potential downward movement, reflecting bearish sentiment.
- Negative Skew (Reverse Skew): Higher IV for OTM calls can indicate expectations of upward movement, often suggesting bullish market sentiment.
Risk Management
Understanding volatility skew is crucial for traders and investors as it:
- Affects option pricing
- Guides hedging strategies
- Informs about market dynamics and potential shifts
Trading Strategies
Various strategies exploit volatility skew, such as:
- Skew arbitrage: Identifying and trading mispriced options between different strike prices.
- Volatility trading: Using skew information to anticipate future market movements.
Historical Context
The concept of volatility skew gained prominence after the 1987 stock market crash (“Black Monday”), which highlighted discrepancies in option pricing models. It underscored the necessity for more sophisticated models incorporating skew to better predict market behavior.
Mathematical Representation
The relationship of implied volatility across different strike prices \( K \) can be represented as:
Where \( \sigma_{\text{impl}} \) is the implied volatility and \( K \) is the strike price. Typical graphs of IV against strike price exhibit a skewed smile or smirk.
Related Terms
- Implied Volatility (IV): The market’s forecast of a likely movement in an asset’s price.
- Out-of-the-Money (OTM): Options with strikes far away from the current price of the underlying asset.
- At-the-Money (ATM): Options with strikes close to the current price of the underlying asset.
- In-the-Money (ITM): Options with strikes favorable to the current price of the underlying asset.
FAQs
Why does the volatility skew exist?
How can traders use volatility skew information?
Does volatility skew remain constant?
References
- Hull, J. C. (2017). Options, Futures, and Other Derivatives. Pearson Education.
- Black, F., & Scholes, M. (1973). The Pricing of Options and Corporate Liabilities. Journal of Political Economy.
Summary
Volatility skew is a critical phenomenon in the options market, reflecting varying implied volatilities across different strike prices. Recognizing and understanding the skew helps traders interpret market sentiment, devise trading strategies, and manage risks more adeptly. As an indicator of investor behavior and market expectations, volatility skew remains an essential tool in the realm of financial analysis.
