Skew

Skew is an options trading concept that describes pricing differences based on an on option’s moneyness. Skew is a measure of implied volatility for out-of-the-money (OTM), at-the-money (ATM), and in-the-money (ITM) options.  Out-of-the-money options have a higher implied volatility than at-the-money and in-the-money options. Therefore, option premiums are typically higher for an OTM option contract.

A high degree of skew indicates that OTM options have higher implied volatility than ATM or ITM options. Skew is used to compare option prices across different strikes and expirations and to measure changes in the volatility surface over time. Skew is depicted visually on a graph as a ‘volatility smile.’

When there is a positive skew, traders should expect to pay higher prices for call options than they would if there was no skew. Conversely, when there is a negative skew, traders should expect to pay higher prices for put options.

Skew can be used to measure market sentiment and risk aversion. If an OTM put’s implied volatility is much higher than ATM puts, it could indicate that investors are expecting a significant downside move in the underlying asset.

Skew can also describe how far out of line a particular strike price's IV may be compared with its at-the-money (ATM) or near-the-money (NTM) counterparts. If an option's IV is much higher than those around it on either side, that strike price has skew.

Option skew chart

Implied volatility skew is a graphical representation of the implied volatility (IV) for different strike prices of call and put options for a specific expiration date. It helps us visualize how IV varies across options with different moneyness.

Skew illustrates the variance in implied volatility associated with different strike prices. Generally, OTM and ITM options exhibit higher IV compared to ATM options. 

For example, we can see IV skew in these SPY option contracts. Far OTM put options have much higher implied volatility than ATM contracts. This is because investors often look to hedge their portfolios against potential downturns by purchasing long puts. The increased demand for these options elevates their IV, making them more expensive relative to near-the-money options with lower implied volatilities.

How to calculate options skew

Skew is a measure of the implied volatility of an option relative to its strike price. It is typically measured using the volatility of out-of-the-money (OTM) options relative to at-the-money (ATM) options. The skew can be calculated by taking the difference between the implied volatilities of two different OTM options with different strikes and dividing by the difference in strike prices.

For example, assume that the implied volatility for a 90 strike call option is 20% and for a 110 strike call option, it is 25%. The skew would be calculated as follows:

Skew = (25% - 20%) / (110 - 90) = 5% / 20 = 0.25

This means that the implied volatility for OTM options is 0.25 higher than ATM options.