Market skew

What Is Market Skew?

Market skew, often referred to as volatility skew or implied volatility skew, is a phenomenon observed in the pricing of options contracts where the implied volatility differs across options with the same expiration date but varying strike prices. This asymmetry in implied volatility suggests that market participants anticipate a higher probability of large price movements in one direction compared to another for the underlying asset. Market skew is a key concept within options trading and financial derivatives, providing insights into collective market sentiment and perceived risk. It challenges the assumption of traditional option pricing models, such as the Black-Scholes model, which typically assume constant volatility across all strike prices.,⁴⁴

History and Origin

Prior to 1987, the options market generally reflected a "flat" volatility curve, meaning that options with the same expiration date had roughly similar implied volatilities regardless of their strike price.⁴³ This implied a normal, or log-normal, distribution of future asset prices, where extreme upward and downward movements were considered equally likely. However, the dramatic stock market crash of 1987 fundamentally altered this perception.⁴²,⁴¹, On "Black Monday," October 19, 1987, the Dow Jones Industrial Average plummeted by 22.6% in a single trading session, the largest one-day percentage drop in its history.,⁴⁰ This sudden, severe downturn highlighted the market's vulnerability to extreme negative events.³⁹,³⁸

In the aftermath of the 1987 crash, investors became increasingly aware of "tail risk"—the risk of rare, high-impact events, particularly sharp market declines. This heightened awareness led to a sustained increase in demand for put options that would provide protection against significant downside movements. T³⁷his increased demand for out-of-the-money (OTM) put options drove their prices higher, consequently boosting their implied volatilities relative to at-the-money (ATM) and in-the-money (ITM) options. This persistent divergence created the "volatility smirk" or market skew commonly observed today, reflecting the market's collective belief that large downward price movements are more probable and thus more expensive to hedge against than equally large upward movements.

³⁶## Key Takeaways

• Market skew describes the difference in implied volatility across options with the same expiration but different strike prices.
• It indicates the market's expectation of future price movements, often showing a higher implied volatility for out-of-the-money put options.,
  ³⁵*³⁴ A "negative skew" or "volatility smirk" is common in equity markets, suggesting a higher perceived risk of downside movements.
• Market skew can be used by traders to gauge market sentiment, identify potential mispricings, and refine their hedging strategies.
  *³³ The phenomenon became more pronounced after the 1987 stock market crash, as investors sought more protection against severe downturns.

³²## Formula and Calculation

Market skew is not represented by a single, universal formula but rather as a measure of the disparity in implied volatilities across various strike prices for options with the same expiration date. It is typically visualized by plotting the implied volatility for each strike price, creating a "volatility curve" or "skew curve."

³¹One common way to quantify a specific aspect of market skew is through the "risk reversal" calculation, which compares the implied volatility of a downside put option to an upside call option. For example, the 25-delta risk reversal involves:

Where:

• Implied Volatility: The market's expectation of future volatility, derived from the option's market price.,
• 25-Delta Call/Put: Options with a delta of approximately 0.25 (for calls) or -0.25 (for puts), representing a certain probability of ending in-the-money (ITM).

³⁰A negative result from this calculation indicates that the implied volatility of the put option is higher than that of the call option, signifying a "downside skew" or "negative skew," which is common in equity markets.

²⁹## Interpreting the Market Skew

Interpreting market skew involves understanding the shape of the implied volatility curve and what it reveals about market expectations. In equity markets, the most common form of market skew is a "negative skew" or "volatility smirk," where out-of-the-money (OTM) put options have higher implied volatilities than at-the-money (ATM) or out-of-the-money call options., T²⁸his shape suggests that investors perceive a greater likelihood of significant downside price movements and are willing to pay a premium for protection against such events. I²⁷t implies a probability distribution of future asset prices that is skewed to the left, meaning a longer "left tail" (higher probability of large negative returns) than a "right tail" (large positive returns).

²⁶Conversely, a "positive skew" (also known as a "forward skew" or "reverse skew" depending on context) occurs when OTM call options have higher implied volatilities., T²⁵his is less common in equity markets but can be observed in commodity markets, for instance, where unexpected supply shocks could lead to sharp price increases., A "flat skew" or "straight skew" indicates that implied volatility is relatively consistent across all strike prices, suggesting that the market does not anticipate significant directional bias in future price movements.

Analyzing the market skew helps investors gauge the level of perceived risk and potential future market direction. A steep negative skew, for instance, often indicates heightened fear or uncertainty in the market.,

²⁴## Hypothetical Example

Consider a hypothetical stock, XYZ Corp., currently trading at $100. An investor is looking at options expiring in three months.

• An ATM call option with a strike price of $100 has an implied volatility of 20%.
• An OTM call option with a strike price of $110 has an implied volatility of 18%.
• An OTM put option with a strike price of $90 has an implied volatility of 25%.

When these implied volatilities are plotted against their respective strike prices, a noticeable market skew emerges. The implied volatility for the OTM put ($90 strike) is significantly higher (25%) than for the ATM option (20%) and the OTM call ($110 strike) (18%). This "smirk" shape illustrates the market's collective belief that there is a higher probability or greater concern about XYZ Corp. falling significantly (requiring more expensive downside protection via put options) than rising significantly. This market skew signals that investors are pricing in a greater risk of a substantial decline in XYZ Corp.'s stock price compared to an equally large increase.

Practical Applications

Market skew provides valuable insights for participants in the derivatives market.

• Risk Management and Hedging: Investors and portfolio managers frequently utilize market skew to assess and manage portfolio risk management. A pronounced negative market skew signals heightened perceived downside risk, prompting some investors to increase their hedging efforts by purchasing OTM put options, even at their higher premiums. F²³or instance, in times of increased market uncertainty, as occasionally highlighted in market commentary, this demand for downside protection tends to increase.
  *²² Option Pricing and Strategy: Market makers and traders use market skew to accurately price options. Options trading strategies, such as volatility arbitrage or spread trading, often explicitly account for the skew to identify potential mispricings or to construct positions that profit from changes in the skew's shape.
  *²¹ Market Sentiment Indicator: The shape and steepness of the market skew can serve as a powerful indicator of prevailing market sentiment. A steep negative skew often suggests a bearish outlook, indicating that market participants are more fearful of market downturns. Conversely, a flattening or positive skew might imply increasing bullish sentiment or a reduction in perceived downside risk., T²⁰his dynamic nature of market sentiment, often influenced by economic reports or earnings announcements, is reflected in the evolving market skew.
  *¹⁹ Quantitative Analysis: Researchers and quantitative analysts study market skew to understand the market's implied probability distribution of asset returns, which often deviates from the normal distribution assumed by simpler models. T¹⁸his information is crucial for developing more sophisticated risk models and trading algorithms.

Limitations and Criticisms

While market skew offers valuable insights, it is subject to several limitations and criticisms:

• Not a Predictive Tool: Market skew is a reflection of current market expectations and perceived risks, not a definitive prediction of future price movements or direction., ¹⁷I¹⁶t reveals what the market is pricing in regarding volatility across strikes, but it cannot guarantee that those expectations will materialize.
• Influenced by External Factors: The market skew can be influenced by a multitude of external factors beyond pure volatility expectations, such as supply and demand dynamics for specific options, interest rates, and macroeconomic events. F¹⁵or instance, a surge in demand for out-of-the-money puts from institutional investors seeking portfolio protection can steepen the skew, regardless of underlying fundamental changes.
• Data Accuracy and Liquidity: The accuracy of market skew analysis relies on the liquidity and pricing efficiency of the options market across all relevant strike prices. In thinly traded options series, implied volatilities might not accurately reflect true market consensus, leading to potentially misleading skew interpretations.
  *¹⁴ Model Dependence: Implied volatility itself is derived from option prices using option pricing models. Different models or slight variations in input parameters can yield slightly different implied volatility values, which in turn can affect the precise shape of the market skew.
• Limited Historical Data (for specific indices): While the concept of market skew has been observed for decades, specific indices that track skew (like the CBOE SKEW Index) have limited historical data, which can make long-term historical comparisons challenging for some market participants.

¹³## Market Skew vs. Implied Volatility

Implied volatility (IV) is a key input in option pricing models and represents the market's forecast of an asset's future price movement., I¹²t is a single value, typically expressed as an annualized percentage, that quantifies how much the market expects an underlying asset's price to fluctuate over a given period. Higher implied volatility generally leads to higher option premiums, reflecting greater expected price swings.,

¹¹Market skew, on the other hand, is the pattern or relationship of implied volatilities across different strike prices for options with the same expiration date., W¹⁰hile implied volatility is a singular measure of expected price movement for a specific option, market skew describes how that expectation varies depending on how far out-of-the-money, at-the-money, or in-the-money an option is. E⁹ssentially, market skew illustrates the asymmetry of implied volatility, showing that not all options on the same underlying asset and expiration have the same implied volatility assigned to them in the market. Implied volatility is a component that contributes to market skew; market skew is the graphical representation or observed characteristic of these varying implied volatilities.

FAQs

What causes market skew?
Market skew is primarily caused by the supply and demand dynamics in the options market, driven by collective investor behavior and perceived risks. Investors often demand more protection against downside movements, leading to higher prices and thus higher implied volatilities for out-of-the-money put options. Major market events, like the 1987 stock market crash, have also played a significant role in shaping the persistent negative skew observed in many equity markets.,,
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7Is a negative market skew always bearish?
A negative market skew (where OTM puts have higher IV than OTM calls) generally reflects a market expectation of greater downside risk and is often interpreted as a bearish signal. However, it is a measure of perceived risk and not a direct forecast of price direction. While it suggests that the market is bracing for potential declines, it does not guarantee a downturn. T⁶raders use it as one piece of information among many for their trading strategies.

How does market skew relate to real-world events?
Market skew reacts to significant real-world events and investor sentiment. For example, during periods of heightened economic uncertainty, such as trade disputes or geopolitical tensions, the demand for downside protection may surge, leading to a steeper negative market skew., ⁵C⁴onversely, positive news or a sustained bull market might see the skew flatten or even become positive in some commodity markets.

Can market skew change over time?
Yes, market skew is highly dynamic and can change constantly based on evolving market conditions, news, and shifts in supply and demand for options. The shape and steepness of the skew can fluctuate, providing continuous insights into changing market expectations and perceived risks. Monitoring these changes is crucial for options traders and analysts.

³Are there different types of market skew?
Yes, the most common types are negative skew (or "volatility smirk"), where OTM puts have higher implied volatility than OTM calls, seen predominantly in equity markets. Positive skew (or "forward skew") occurs when OTM calls have higher implied volatility, often seen in commodity markets., A "flat skew" or "straight skew" indicates relatively uniform implied volatility across strikes, which is less common. T²he term "volatility smile" describes a U-shaped curve where both OTM calls and puts have higher IVs than ATM options, indicating expectations of large movements in either direction without a strong directional bias.,¹