If implied volatility were a single number for an underlying, every strike on the option chain would show the same figure. It does not. Look across the strikes of an index and you will usually see implied volatility rise steadily as you move to lower strikes.
That pattern is called volatility skew. It is one of the most useful things to understand about option pricing, because it quietly affects the cost of almost every strategy.
What skew is
Implied volatility is the volatility figure that makes an option's market price consistent with a pricing model. Each strike has its own option price, so each strike has its own implied volatility.
When these are plotted across strikes, the result is rarely flat. For equity indices, the usual shape is a downward slope from left to right: out-of-the-money put options at lower strikes carry higher implied volatility, at-the-money options sit in the middle, and out-of-the-money call options at higher strikes carry lower implied volatility. This is often called a put skew or a negative skew.
A related pattern, where implied volatility rises on both sides of the current price, is called a volatility smile. It is more common in some other markets and in individual stocks around certain events.
The practical meaning is simple: an out-of-the-money put option is priced as if the market expects more volatility than an equally distant out-of-the-money call option. Protection against a fall costs more than a bet on a rise of the same distance.
Why it exists
Demand for protection. Investors holding shares want insurance against falls. Buying put options is the most direct way, and steady demand from hedgers pushes their prices up. There is no equivalent natural demand for protection against rallies.
Markets fall faster than they rise. Equity markets have tended to rise gradually and fall sharply. Large downward moves, including gaps, are more common than equally large upward moves over short periods. Sellers of downside options demand more compensation for that tail.
Volatility rises in falls. When markets fall, volatility usually increases. A put option that moves into the money during a fall also benefits from that rise in volatility, which makes it more valuable and justifies a higher price.
Sellers' risk appetite. Selling far out-of-the-money put options carries the risk of large, sudden losses. Fewer participants are willing to take that risk at low prices.
Skew is not a mispricing to be exploited automatically. It reflects real features of how markets behave and who wants what kind of protection.
Reading it on the option chain
Most option chains display implied volatility for each strike. To see the skew:
Compare equally distant strikes. Look at a put option a certain distance below the current price and a call option the same distance above. In an index, the put will usually show the higher implied volatility.
Watch how steep it is. The difference between implied volatility at lower and higher strikes changes over time. During market stress, the skew often steepens as demand for protection jumps. In calm periods it may flatten.
Compare across expiries. Near expiries and far expiries can show different skews. Short-dated skew can react sharply to news.
An illustrative picture: with an index at 24,000, a put option at 23,500 might show implied volatility around 17 percent, the at-the-money options around 14 percent, and a call option at 24,500 around 12 percent. The figures are examples, not market data, but the shape — higher on the left, lower on the right — is typical for an index.
Be careful with illiquid strikes. Implied volatility figures for thinly traded strikes can be distorted by wide bid-ask spreads. Use strikes with real trading activity when judging the shape.
What it means for strategies
Protective puts cost more than intuition suggests. Buying downside protection means buying the most expensive part of the skew. It is still worth doing for many hedgers, but the cost should be expected.
Put spreads partly offset the skew. In a bear put spread, you buy a higher-strike put option and sell a lower-strike one. The sold put carries higher implied volatility, so you receive relatively more for it, reducing the net cost.
Collars use the skew. A collar buys a put option and sells a call option on a holding. Because the put is relatively expensive and the call relatively cheap, a collar often costs more than a symmetric one might suggest, or requires a call strike closer to the price.
Short strangles collect more on the put side. The put leg of a strangle usually brings in more premium than an equally distant call leg. That extra premium reflects the extra risk of a sharp fall.
Risk reversals express a view on skew. Selling a put option and buying a call option, or the reverse, is partly a bet on the shape of skew as well as direction.
Understanding skew does not tell you which strategy to choose. It tells you why certain strategies cost what they do, and which part of a structure you are paying for.
Skew in individual stocks
Single stocks can show different skew patterns from indices. Before results or major announcements, implied volatility often rises across the board and may show a smile, with both downside and upside options priced higher, because a large move in either direction is plausible.
Some stocks with strong takeover or upside-event potential can show relatively higher implied volatility on call options than an index would.
Liquidity is also a bigger issue in stock options, so skew estimates for many stocks are less reliable than for the main indices.
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Frequently Asked Questions
What is volatility skew?
The pattern in which options at different strikes on the same underlying carry different implied volatilities. In equity indices, out-of-the-money put options usually carry higher implied volatility than equally distant call options.
Why do out-of-the-money puts cost more?
Steady demand from investors seeking protection, markets tending to fall faster than they rise, volatility rising during falls, and sellers demanding more compensation for downside tail risk.
What is the difference between skew and smile?
Skew is a slope where implied volatility is higher on one side, usually lower strikes for equity indices. A smile is a curve where implied volatility rises on both sides of the current price.
How does skew affect a bear put spread?
The lower-strike put option you sell carries higher implied volatility, so you receive relatively more for it, which reduces the net cost of the spread.
Does skew change over time?
Yes. It often steepens during market stress as demand for protection rises, and flattens in calm periods. It can also differ between expiries and around company events.
Related Reading
- Patna options course
- The cost of downside protection
- How a collar uses both sides
- Implied volatility on the chain
- Why premiums jump after sharp moves
- Strangles and the put-side premium
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