A Beginner’s Guide to Trading Volatility Skew
Financial market trading and investing need a solid understanding of many ideas and indicators to guide your decisions. Options traders employ volatility skew. This article explains volatility skew, how it is computed, and why traders care.
Volatility Skew?
Implied volatility skew is the unequal distribution of implied volatility across striking prices of the same underlying asset and expiry date. At its simplest, it compares implied volatility levels between OTM, ATM, and ITM options.
The horizontal axis of a volatility skew chart shows strike prices and the vertical axis implied volatility. The skew may be positive (greater implied volatility for OTM options), negative (higher implied volatility for ITM options), or zero (same implied volatility across all strikes).
Volatility Skew Calculation
Calculating volatility skew involves comparing option implied volatility at various strike prices. The most frequent way is to compare the implied volatility of at-the-money options (typically the strike price closest to the underlying asset’s market price) to out-of-the-money or in-the-money options.
Let’s suppose ATM options have 20% implied volatility, OTM options 25%, and ITM options 15%. The volatility skew would be positive, showing greater implied volatility for OTM options than ATM and ITM options.
Why Does Volatility Skew Matter?
Options traders need volatility skew to understand market sentiment and risks. It helps traders analyze how market participants price options across strikes and identify overvaluation or undervaluation.
Many traders utilize volatility skew to guide their strategy. A positive skew may imply more demand for OTM options, indicating traders are more negative about the underlying asset. This information may help choose option strategies like buying or selling options, spreads, or other sophisticated strategies.
Additionally, volatility skew may be used to hedge. For instance, a trader with a long stock position may employ volatility skew analysis to find OTM put options with greater implied volatility. This improves downside risk hedging.
Conclusion
Options traders must comprehend volatility skew. Traders may assess market sentiment and risks by comparing implied volatility across strike prices. It may guide trading and hedging. Volatility skew study may help traders understand option pricing dynamics and improve their trading results.
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