Options are heavily priced off the expected volatility of the underlying asset. Options of the same maturity would normally be expected to have the same implied volatility irrespective of the strike price. Nonetheless, in practice, the implied volatility can vary materially depending on the strike. This is called the volatility skew.
We’ll cover three forms of volatility skew, known as the smile, forward skew, and reverse skew.
Volatility skew is found by plotting implied volatilities on the vertical axis and strike prices on the horizontal axis.
When there is more demand for options that are further in-the-money (ITM) or out-of-the-money (OTM), this will be reflected in higher implied volatility at the far left and far right of the curve. This is referred to as a “volatility smile” with the shape that it makes.
The symmetric distribution is common in currency/forex markets. This means that OTM options are typically bid up by traders betting on big moves in the currency. The above diagram shows euro futures against the US dollar.
There are two types of “volatility smirks”: forward skew and reverse skew.
Forward Volatility Skew
For forward skews, the implied volatility at the higher strikes is greater than those at the lower strikes. This means that OTM calls and ITM puts would be in greater demand than OTM puts and ITM calls.
Forward options skew is common in some commodities markets.
For example, in agricultural products and natural gas, the weather is an important driver of the commodity’s price because it affects supply. Inclement weather, fires, frosts, droughts, and other natural disasters can materially disrupt production. Such events can be very influential on these markets, much more than a continuation of typical weather patterns, which are already baked into the price.
This means that businesses dependent on these commodities are likely to seek protection against these events by purchasing OTM calls as a hedge. This creates a forward skew, as can be seen in the natural gas market.
It is currently present in coffee as well:
Reverse Volatility Skew
Reverse volatility skew is common in equity markets and in some commodities, such as oil.
Here is the E-mini S&P 500 futures reverse skew, which exhibits heavy reverse skew:
Below is the reverse skew in WTI crude oil:
Reverse skew shows that OTM puts and ITM calls are in greater demand than OTM calls and ITM puts.
In the case of equities, most traders are long this asset class. Equities are among the highest-returning investment classes, so most want to have long exposure to it.
At the same time, stocks are volatile and this increases the demand for OTM puts and ITM calls, which protect downside.
OTM puts act as a hedge on current stock holdings. ITM calls allow one to participate in the uptrend of a stock market while minimizing losses because the most you can lose is the premium paid for the option.
Additionally, ITM calls offer not only downside protection but offer embedded leverage. One can buy stocks without making a large capital outlay like they would when buying the underlying securities.