Skew, meaning volatility skew, is the difference between implied volatility amounts of different strikes on the same date. Implied volatility is the expected percentage range over one year–based on option prices–with 68.3% confidence.

Intermediate: Intro to Skew

Skew is one of the main edges (competitive trading advantages) to look for in an options trade. Sometimes it is a penalty dragging down a good trade, but it is nonetheless important to understand the extent of how much it can challenge a trade if consciously accepting to take the opposite side of a skew advantage. 

Skew is generally understood to be a dynamic in vertical trades (all strikes on the same date); in contrast, if trading horizontally across different expirations, then it would be a term structure edge (forward implied volatility on one day being stronger than the other). The idea of using skew for edge in a vertical spread is simply to buy a strike with a lower IV% than the strike being written (sold to open).

Advanced: Strategy

With ratios, the effect of skew can be compounded by buying extra contracts with the lower IV% (a backspread) or writing extra contracts with the higher IV% (a frontspread). However, take care that frontspreads can be very dangerous because their risk is undefined if there are no other dynamic hedging measures in place such as emergency stop-limits (emergency conditional orders that will open positions in the underlying which are trading in the direction of a breakout trend). 

Expert: Analyzing Skew

[Volatility] skew is often evaluated in terms of a volatility smile (a 2D visualization of the IV% for all strikes on the same date), which places deltas, strikes, or moneyness on the x-axis, and [log scale] implied volatility on the vertical. As a reminder, implied volatility is the expected percentage range–over the next year–based on option prices, with 68.3% confidence. Also, the vertical axis is in log scale to create room for potentially infinite expansion of implied volatility. 

If there was no such thing as skew, then IV would be flat across all strikes. A volatility smile also shows the relative expensiveness of calls vs puts all in one picture. However, it is not always shaped as a smile, which is why, as a convention for extra precision, we like to refer to call skew and put skew in isolation, with positive skew meaning that OTM (out of the money) strikes have a higher IV%.

<Volatility smile retrieved from IB’s Trader Workstation>

Skew can also be observed in a higher-dimension model known as the volatility surface when term structure (IV over time) is combined with it. This is essentially combining all available volatility smiles and comparing them over different maturities; the more granular the time periods on the surface the more accurate it is.

<Volatility surface retrieved from IB’s Trader Workstation>

Expert: Dynamics

Regarding the dynamics, “skew increases as maturity decreases” (Bennett, 2014, p. 262). Also, “in many skew models puts with deltas of -25 and calls with deltas of +25 tend to have the greatest skew sensitivity” (Natenberg, 2015, p. 499). Putting this together, a trader can generally hit hardest on a skew edge if writing around 25 delta on a relatively short duration. 

If taking the counterparty to skew and accepting it as a disadvantage because the rest of the trade is that strong, it is worthwhile to do a simple measure of the difference in skew to see how strong that penalty is, and double-check whether it is really worth it. This is sometime soon referred to as zeta, which would be the difference in IV% between an OTM strike (such as around 25 delta) and the IV% ATM (at the money).