After the many years I’ve taught option trading, skew is probably one of the least understood concepts. In theory, applying skew is really easy. You want to sell thigs that are more expensive and buy things that are less expensive. Most people get that, but the issue with skew is that it’s not the price, but the pricing.

The trading strategy that is the most impacted by skew are verticals and all vertical-based strategies. When you start to add up all the strategies affected, you start to realize how important skew really is.

As you study verticals, you’ll find that the pricing is impacted by two things, probability and skew. Handling probability is easy, just pick a strike that has the desired probability of expiring in-the-money (ITM). Understanding skew does become more difficult to grasp, but hopefully this primer will help work out the kinks for you.

History of Skew

In order to appreciate skew, it helps to start with a little history lesson.

Option traders are always pricing in the future movement of the stock or index they’re trading. Until 1987, the options market had always assuming that there was an equal chance of a large up-move or down-move (normal distribution). Black Monday changed that. The market suddenly realized that markets crash downward!

This was a painful realization for those that were long delta and particularly those that had sold put options. They were undercompensated for the risk of a market crash. Suddenly, the market was in a position where it had to price in the asymmetry of extreme movement for the major market indices.

Skew is Intuitive

The notion that stock market returns are skewed makes intuitive sense. Sure, there’s the saying that the “market climbs up the stairs and falls out the window,” but let’s take that a step further.

For example, if I told you that the S&P 500 was going to move 10% the next trading day, which direction would you bet it would go? It’s either a 10% move higher or a 10% move lower. To answer this, you would need to think about how many times the market moved higher by 10% in one day versus falling by that amount. Of course, you would have to conclude that markets crash downward and now upward.

Another way to think of skew is that there is a higher frequency of small moves higher than would be predicted given a normal distribution. Watching the price movement of most stocks over long periods of time will help you to see this.

Skew and Implied Volatility

This understanding of market returns can be very well summarized by the following image of reverse or negative skew.

You’ll notice that a symmetrical (normal) distribution has an equal chance of a large move higher and lower. Also, the mean, median and mode are all the same value.

When you look at negative skew, the more frequent occurrence (mode) is higher than the mean. However, the long tail to the left represents the higher frequency of large downward moves than a normal distribution would predict.

Looking at positive skew, it’s the compete opposite. The most frequent occurrence are small down moves but with greater potential for large upward moves. This condition more aptly describes stocks that are heavily shorted and frequently commodities.

The implied volatility (IV) of options must represent this reality and luckily for traders, it does. If you were to think about how traders would price negative skew, the out-of-the-money (OTM) put options would have to be more expensive than the OTM call options. This condition is called Reverse Volatility Skew.

Skew and the Implied Volatility Smile

A normally distributed market or stock will not exhibit skew in its implied volatility. Again, prior to 1987, the implied volatility curve could be accurately described as a “smile.”

In the case of a normal distribution, the volatility smile is represented by the lowest implied volatility being at-the-money (ATM). As you move OTM on the call and put side, the volatility increases incrementally the same. The highest IV is the furthest OTM call and put strikes.

That type of curve isn’t typical. The more likely scenario is a reverse skew that is pricing in the negatively skewed distribution of returns. The image below shows the current skew on the S&P 500 Index options.

Notice the lack of symmetry for the OTM calls and OTM puts on the 15 JAN 21 expiration. The put IV is rising much more sharply and the call IV is actually falling briefly as the strike move OTM. What has historically been a volatility smile is now a smirk.

Skew and Vertical Trading

Most beginners in option trading find themselves never considering implied volatility and skew when selecting a strategy. Typically, they look at the share price and pick a strategy that suits them. While easy to implement, this has them frequently taking pricing that is less than advantageous. Understanding the impact of implied volatility and skew takes your option trading to the next level.

A vertical trade involves buying and selling calls or puts within the same expiration and different strike prices. Because you’re trading different strike prices within the same expiration, IV skew is emphasized.  Here is a snapshot of the option chain for the SPDR S&P 500 ETF (NYSEARCA: SPY). 

As you work your way OTM on the call side on the left, the implied volatility is falling. As you work your way OTM on the put side on the right, the implied volatility is rising. This is reflecting reverse implied volatility skew.

Setting up a vertical involves buying one strike at a particular IV and selling another with a different IV. If you take a moment to think about it, which IV would you rather buy or sell? Of course, your intuition should lead you to sell the higher IV and buy the lower IV. Doing this would make you credit higher or your debit lower when entering the trade.

The implication of this understanding means that you’ll only trade verticals in the direction that the skew favors. For reverse skew, that means bearish verticals whether long or short.

Skew and Vertical Example

Let’s take a closer look at the impact of skew using a couple of examples.

The example below is an in/out long vertical spread on the SPY. An in/out spread involves buying the ITM option and selling the OTM option. In this example, the trade is using the 15 JAN 21 expiration and involves buying the $369 put and selling the $367 put for an $0.85 debit. This trade has about a 50/50 shot of making money at expiation and it has better than a 1:1 reward-to-risk. This trade is bearishly biased and is using the skew in its favor.

The next example flips the trade to the call side. In the example below, the ITM $367 call is bought and the $369 is sold for a debit of $1.18. Tis trade similarly has a 50/50 probability, but a much less favorable reward-to-risk. This trade is risking $118 per contract to make $82 compared to risking $85 in the put example with a $115 max gain.

Conclusion

This should be a huge revelation if you’re not familiar with skew. It should also make a lot of sense since you’re selling the high IV option in the long put vertical example and you’re buying the high IV option in the long call vertical. Hopefully this helps you take the next step in your option trading of emphasizing strategies that are designed to exploit implied volatility. This knowledge will help you prevent placing square pegs in the round holes of trading implied volatility skew.