Definition
Volatility Skew, in finance, refers to the discrepancy or variation in implied volatility levels for options across various strike prices. This discrepancy or skew typically materializes when the market participants’ perception of risk in one direction significantly surpasses the risk perception in another direction. Essentially, it demonstrates the market’s outlook on an asset’s likelihood for drastic changes in price.
Key Takeaways
- Volatility Skew, also known as skew, is a financial term referring to the differences in implied volatility of option contracts which have the same expiration date but different strike prices. It’s an anomaly that counters a basic assumption of the Black-Scholes option pricing model; that is, options with different strike prices but same expiration should have the same implied volatility.
- Traditionally, volatility skew has two types: Smirk and Smile. A smirk skew shows higher implied volatility for lower strike price options, implying a larger probability of a market crash. On the other hand, a smile skew presents equal higher implied volatility for both lower and higher strike price options, which suggests uncertainty about price direction.
- Volatility skew is important to investors as it can help predict future market volatility and pricing behavior. It allows traders to examine market sentiment towards an asset. A significant skew could indicate a future increase or decrease in the price of the underlying asset.
Importance
Volatility skew, also known as implied volatility skew or just skew, is an important concept in finance because it indicates the disparity in the implied volatility (IV) of options on the same underlying security but with different strike prices.
It’s significant because it reflects investor sentiment and market expectations about future price changes of the underlying asset.
A positive skew implies that out-of-the-money put options have higher implied volatility than out-of-the-money call options, indicating a greater perceived risk of a price drop, while a negative skew implies the opposite.
Understanding volatility skew can thus provide valuable insights for options pricing, hedging strategies, and risk management.
Explanation
Volatility skew, commonly known as the option skew, is a vital concept primarily used in the finance industry to gauge market sentiment and anticipate price fluctuations. The presence of volatility skew indicates that investors are forecasting a considerable market shift in the future and are adjusting their investment strategies accordingly.
It is a common tool used by traders in the options market to predict the likelihood of significant swings in a security’s price, thereby helping them refine their investment strategies and hedging techniques. Primarily, volatility skew serves as a risk management tool.
By visibly portraying the disparities in perceived volatility for options on the same underlying asset but with different strike prices, it provides essential insight into market participants’ expectations. This information can influence an investor’s decision to buy or sell options and choose the correct strike price.
Similarly, for option pricing models, the skew is used to refine the model and adapt to the observed market prices better. Therefore, rather than focusing on the definition, the utility of volatility skew in the financial world is affiliated with its application in determining market sentiment, risk assessment, and tactical financial planning.
Examples of Volatility Skew
The Black Monday (1987) Effect on Volatility Skew: This was one of the most significant events that had a substantial impact on volatility skew in the financial world. Before the 1987 crash, the implied volatilities for options at various strike prices (both in and out of the money) remained about the same. However, after Black Monday where the stock market experienced a sudden and severe drop, the observation changed significantly. The implied volatilities for out-of-money put options (options that become profitable when the market declines) increased because the potential for dramatic market declines was factored in by market players. This created a steep “skew” in volatility.
The Effect of the 2008 Financial Crisis on Volatility Skew: The 2008 global financial crisis is another significant instance where the volatility skew was observed. The crisis led to a broad market downturn, which increased the demand for protective put options. As a result, the implied volatility for these options also increased, creating a skew. The severity of the financial crisis made the skew more pronounced, as there was a high level of insecurity in the market, and investors were willing to pay more for protection.
The Impact of Coronavirus (COVID-19) on Volatility Skew: When the pandemic hit in early 2020 and global stock markets crashed, there was a high level of uncertainty and fear in the market. This situation led to a significant increase in the demand for out-of-money put options, which protect against downward market movements. As a result, the implied volatility for these options increased compared to the at-the-money options, creating a pronounced volatility skew.
FAQs About Volatility Skew
What is Volatility Skew?
Volatility skew, also known as option skew or skew, refers to the disparity of option implied volatility (IV) for option contracts on the same underlying asset but with different strike prices. It represents the difference in perceived risk underlying different strike prices. Skew can take on different shapes based on market conditions.
What causes Volatility Skew?
Volatility skew is typically caused by investor sentiment and expectations about the market or particular security. In the options market, higher implied volatility typically indicates a greater expected change. Therefore, a volatility skew that shows higher implied volatility for options with higher strike prices could suggest that traders anticipate a potential upside movement from the underlying asset.
What are the types of Volatility Skew?
There are two basic types of volatility skew – Positive Skew and Negative Skew. Positive Skew (also known as forward skew or normal skew) implies out-of-the-money options have higher implied volatility. Negative Skew (also known as reverse skew) implies in-the-money options have higher implied volatility.
How is Volatility Skew measured?
Volatility Skew is measured by plotting the strike prices against their respective implied volatilities. Differentiating these values can express the rate of change, which is often described as the ‘slope of the skew’.
What is the importance of Volatility Skew?
For traders, an understanding of volatility skew is important because it can affect the price of options and provide clues about market expectations for future price volatility. It can be used to make predictions about market direction, manage risk, and identify potential trading opportunities.
Related Entrepreneurship Terms
- Implied Volatility (IV): This refers to the market’s forecast of a likely movement in a security’s price. It is generally used to price options contracts and is directly influenced by the supply and demand of the underlying options and by the market’s expectation of the stock’s price direction.
- Black-Scholes Model: A mathematical model used to calculate the price of an option. The driving idea behind the model is to hedge the option by buying and selling the underlying asset in just the right way and consequently eliminate risk.
- Strike Price: This is the fixed price within an options contract at which an investor can buy (call option) or sell (put option) the underlying asset.
- Smile Effect: This refers to a long-observed pattern in which at-the-money options tend to have lower implied volatilities than in- or out-of-the-money options. The graph hence looks like a smile.
- Option Greeks: These are named after Greek letters, and they measure the sensitivity of the option’s price to various factors, including changes in the underlying asset price, volatility, time decay and the risk-free rate of interest.
Sources for More Information
- Investopedia is a resourceful website loaded with finance and investment terms and concepts.
- Fidelity provides various articles, ideas, and tools related to financial planning and investing.
- CNBC offers business news and real-time financial market coverage.
- Corporate Finance Institute offers various educational content about finance-related topics and concepts.
