What Is Volatility Skew and What Causes It?

Volatility quantifies the degree of price variation an asset experiences over a period, reflecting how quickly prices move. While often considered a single metric, volatility exhibits variations crucial for market participants. This article clarifies volatility skew, explaining its nature, causes, observation methods, and market implications.

Defining Volatility Skew

Implied volatility represents the market’s expectation of future price fluctuations for an underlying asset. Unlike historical volatility, which measures past price movements, implied volatility is forward-looking and derived from current option prices. It is a key input in option pricing models, as higher implied volatility generally leads to higher option premiums.

Volatility skew is the phenomenon where implied volatility is not uniform across all options on the same underlying asset with the same expiration date. Instead, it varies depending on the option’s strike price. Theoretically, if options were priced based on simplified models and market expectations were symmetrical, implied volatility would be constant across all strike prices, forming a “flat” surface.

However, real-world markets consistently deviate from this theoretical flatness. This deviation manifests in a specific pattern: out-of-the-money (OTM) put options often exhibit higher implied volatility compared to at-the-money (ATM) options. Conversely, OTM call options frequently display lower implied volatility for the same expiration date. This means options protecting against downside moves are priced with a higher expectation of future volatility.

This variance indicates the market assigns different probabilities to various price outcomes. The market anticipates extreme price movements, especially to the downside, are more likely than a simple statistical model might suggest.

Factors Driving Volatility Skew

One factor contributing to volatility skew is investor concern about substantial downside price movements, often termed “crashophobia.” Market participants are more apprehensive about large declines than equivalent upside gains. This fear translates into heightened demand for out-of-the-money (OTM) put options, which protect against sharp market downturns. This increased demand drives up put option prices, elevating their implied volatility.

Another element is the “leverage effect,” an observation in financial markets. This effect describes a company’s stock volatility increasing when its stock price falls. As a stock price declines, its debt-to-equity ratio can increase, making the company appear more leveraged and riskier. This perceived risk often correlates with higher future volatility.

Supply and demand dynamics also shape volatility skew. Institutional investors and portfolio managers frequently purchase OTM puts to hedge against market crashes. This consistent demand for downside protection creates an imbalance in the options market. Strong demand for OTM puts, coupled with potentially excess supply of OTM calls, leads to lower implied volatility for those options.

Observing and Categorizing Skew

Volatility skew is observed by plotting the implied volatility of options against their strike prices for a specific expiration date. This graphical representation forms a curve, illustrating the market’s differing volatility expectations.

In equity markets, the most prevalent pattern is a “volatility smirk.” This curve shows implied volatility highest for low-strike out-of-the-money (OTM) put options. As the strike price increases towards at-the-money (ATM) and then to high-strike OTM call options, implied volatility gradually decreases. This pattern reflects the market’s concern for downside risk in equity investments.

Foreign exchange (FX) options markets frequently exhibit a more symmetrical “volatility smile.” Here, implied volatility tends to be higher for both OTM put and OTM call options compared to ATM options. This smile shape indicates the FX market perceives significant two-way risk, with concerns about both strong appreciation and depreciation of a currency.

Commodity options can display diverse skew patterns, differing from equities or currencies. Some commodities may show a “reverse skew” or “forward skew,” where out-of-the-money calls have higher implied volatility than puts. This can occur in markets like crude oil, where risks of supply disruptions or geopolitical events might lead to greater demand for upside exposure, elevating call option implied volatility.

Market Insights from Volatility Skew

The characteristics of volatility skew, such as its steepness, indicate overall market sentiment and perceived risk. A steeper equity smirk, for example, signals increased investor fear regarding potential downside movements. The skew’s shape provides insight into how the market prices different risk scenarios.

Volatility skew also implies the market assigns a non-normal probability distribution to future asset prices. The market anticipates a higher probability of extreme downside moves, known as “fat tails,” than a standard normal distribution model would predict. This means severe market events, while rare, are considered more likely.

Volatility skew represents how the market prices “tail risk”—the risk associated with rare, high-impact events. It quantifies the premium investors pay for protection against or speculation on extreme price movements.

The existence of volatility skew directly influences the relative cost of different strike options. Because options are priced using implied volatility, OTM puts in equity markets, for instance, are more expensive than if implied volatility were flat across all strikes. This directly impacts the cost of hedging strategies and the profitability of various option trades.