What Is Volatility Skew?

Sometimes known as the volatility smile, volatility skew is the difference in implied volatility between out-of-the-money, in-the-money, and at-the-money options. Volatility skew is affected by investor sentiment, as well as supply and demand in the market. It provides insights for investors as to whether there is an overall preference for fund managers to buy puts or calls.

The volatility skew is a relatively recent phenomenon in the context of the long history of global markets, coming about as a result of a major stock market crash in the late 1980's. By reviewing the aftermath of the crash, we can explore how and why the skew exists, understand its importance to traders, and learn how to leverage the insights it provides to improve our options trading results.

The Black Monday Crash 

On Oct. 19, 1987, the United States stock market plunged. Known as Black Monday, the stock market crashed, experiencing the largest one-day percentage drop in history with the S&P 500 declining more than 18%.

It precipitated a knock-on effect to markets around the world, with every one of the 23 major markets around the world suffering declines. Almost half suffered declines of 29% or more.

The crash was so severe that it caused worldwide losses estimated at $1.7 trillion US dollars, and sparked fears of major economic instability and the resurgence of the Great Depression. While markets and economies eventually recovered, Black Monday served as an important lesson for investors in managing downside risk.

In response to the crash, investors sought ways with which to protect their portfolios. One of the main ways to do this was through option insurance. The surge in demand from investors for option insurance helped evolve the options market into what we see today.

One of the key evolution stages of the options market was the formation of the volatility skew. In the next section we will explore how this came to be.

Why Volatility Skew Exists 

To understand why volatility skew exists, it’s important to appreciate the composition of stock market participants. In general, the majority of market participants go net ‘long’ with stocks, meaning they hold stocks with an expectation that they will go up in price over time.

In addition, the market is composed of many different types of participants, from individuals, trading firms, and governments, through large scale hedge funds, mutual funds, and retirement schemes. The largest participants can hold positions worth hundreds of millions and even billions of dollars.

As a result of the size of their portfolios, getting into and out of positions is difficult. These groups can’t just sell their entire position on a whim, so they need to have a way to protect themselves from market downturns. The way these groups protect themselves is to purchase portfolio insurance in the options market.

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Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are ...

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Farah Kincaid 1 month ago Member's comment

This is excellent- thanks for sharing.