What it means
In the original option pricing theory, every option on the same asset and expiry should share one volatility number. Real markets disagree.
Plot implied volatility against strike price and the line usually slopes downwards from low strikes to high strikes, which is what practitioners call the skew. The reason is largely about who wants what.
Investors holding shares want downside insurance and buy puts, while sellers of that insurance demand a premium for taking on crash risk, so low-strike options are bid up. Markets also know that equity falls tend to be faster and sharper than equity rises, which justifies pricing the downside more expensively.
For anyone hedging, the skew is a direct cost. Buying a put 10% below the current price is not simply a matter of paying for the lower strike; you also pay a higher volatility input, which compounds the premium.
This is why collar structures, where you fund a put by selling a call, are popular: the expensive put is partly paid for by the relatively cheap call. The steepness of the skew moves with sentiment and is watched as a signal in its own right.
A skew that steepens sharply while the index is still rising suggests large holders are quietly buying protection, which some desks read as a warning sign before it shows up in the headline index. Not every market skews the same way.
Commodities such as crude oil often show a reverse skew with expensive upside calls, because the feared shock for a consumer of oil is a price spike rather than a collapse, so the shape of the curve reflects who the natural hedgers are.
In practice
Real-world examples.
Example
A family office wanting to protect a large concentrated shareholding finds the puts it needs are priced at a much higher implied volatility than at-the-money options, and switches to a collar to offset the cost by selling upside calls.
Example
A trading desk monitors the skew on a bank index and notices it steepening over a fortnight while prices drift higher, prompting a review of the desk's own downside exposure.
Example
A corn processor discovers that call options on its raw material carry higher implied volatility than puts, the opposite of the equity pattern, because farmers hedge downside and processors bid for upside protection.
Think of it
“Volatility skew means different strikes have different IVs-usually puts are more expensive.
Formula
Calculation
A common practical measure is the 25-delta risk reversal:
Risk reversal = Implied volatility of the 25-delta call - Implied volatility of the 25-delta put
An index trades at 5,000. For options expiring in three months, the desk quotes implied volatility of 26% on the 25-delta put (a strike well below the current level), 20% on the at-the-money options, and 17% on the 25-delta call (a strike well above).
Risk reversal = 17% - 26% = -9 volatility points. The negative sign confirms a classic downside skew. Measured another way, the put-over-call skew is 26% - 17% = 9 points, and the put trades 6 points above at-the-money volatility (26% - 20%).
The practical effect is that a hedger buying that put pays a premium priced off 26% volatility rather than the 20% headline figure, so the protection costs materially more than a single-volatility model would suggest.Case study
Seen in the real world.
The following is an illustrative and fictional example. Windermere Sentinel Capital, an invented multi-asset fund, budgeted its annual portfolio insurance using at-the-money implied volatility as the pricing input, because that was the number quoted on its risk dashboard.
When the team went to execute a programme of 10% out-of-the-money index puts, the actual cost came in roughly 45% above budget. The dashboard showed volatility at 20%, but the strikes the fund actually wanted were trading nearer 27%, and nobody had reconciled the two figures before the board approved the spend.
Windermere rebuilt its reporting to show implied volatility at the specific strikes it habitually hedged, not just at the money, and added the risk reversal as a standing line item. The illustrative lesson is that a single headline volatility number can badly misprice a hedge whenever the skew is steep.
Watch out
Common mistakes.
- Pricing a hedge off at-the-money implied volatility when the strike you actually need sits far from the money and carries a much higher figure.
- Assuming skew is a pricing error to be arbitraged away, when it reflects genuine demand imbalances and real crash risk.
- Expecting every asset class to skew towards expensive puts, when commodities and some currencies often skew the other way.
Questions
People also ask.
Why do puts usually cost more than calls in equity markets?
Because holders of shares buy downside protection in size while sellers charge extra for crash risk, and equity falls historically happen faster than rises.
Is a steep skew a reliable market timing signal?
It is a useful sentiment indicator rather than a timing tool, since skew can stay steep for long stretches without any sell-off following.
How is skew measured in practice?
Commonly by the 25-delta risk reversal, or by the difference in implied volatility between a fixed percentage out-of-the-money put and call.
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