Understanding Volatility Skew and How It Affects Your Trades

Volatility skew refers to the pattern where implied volatility varies across different strike prices for options on the same underlying with the same expiration. In equity markets, the most common pattern is a negative or reverse skew, where out-of-the-money puts have higher implied volatility than at-the-money or out-of-the-money calls. This skew exists because demand for downside protection, in the form of puts, consistently exceeds demand for upside speculation through calls. The crash of 1987 permanently embedded this risk premium into options markets.

The practical implication of skew for traders is that not all options of the same delta are priced equally. A 25-delta put will typically have a higher implied volatility than a 25-delta call on the same stock. This means that selling put spreads collects more premium per unit of risk than selling call spreads at equivalent delta levels. Traders who understand this asymmetry can construct more efficient positions by exploiting the elevated premium on the put side.

Skew is not static. It steepens during market selloffs as demand for protective puts surges, and it flattens during strong rallies as put demand wanes and call demand increases. Monitoring changes in the slope of the skew curve over time reveals shifts in institutional positioning and risk appetite. A sudden steepening of skew, even without a corresponding drop in the underlying price, can signal that large players are hedging for a potential decline.

For trading applications, compare the current skew to its historical average. When skew is steep relative to its own history, put credit spreads and put ratio spreads are attractive because you are selling overpriced downside volatility. When skew is flat, risk reversals, which involve selling a put to buy a call, become less expensive and more attractive for directional bullish bets. Advanced traders construct positions that are explicitly long or short skew, profiting from the normalization of skew toward its historical mean.