Volatility Smile
When options started trading on the stock exchange, the volatility skew was very different. Most of the time, out-of-the-money options were traded at inflated prices. In other words, the implied volatility of both calls and puts increased as the strike price moved away from the current stock price, resulting in a “volatility smile” that could be observed when plotting price data.
Impact of “Black Monday”
Since Black Monday (October 19, 1987), out-of-the-money put options have become more attractive to buyers due to the potential for substantial payoffs. Additionally, these options became appealing as insurance for portfolios against the next market catastrophe. The increased demand for put options seems to be persistent and leads to rising prices (i.e., an increase in implied volatility). Thus, the “volatility smile” was replaced by “volatility skew.” This remains true even as the market has risen to new highs.
Frequently Asked Questions (FAQs)
How do you trade using volatility skew?
Measuring volatility skew can help identify options with the highest and lowest premiums. This is particularly important for traders who sell one contract to hedge the price of another. For example, a trader who is bullish on a stock can use volatility skew to identify the best contracts for a bullish selling strategy.
Why is volatility skew stronger for options that expire in the near term?
The closer options get to expiration, the greater the need for increased volatility to reach out-of-the-money strike prices. This means that implied volatility increases because the underlying stocks need to move a greater distance and faster to hit the out-of-the-money strike price before expiration. When an option has more time to reach the strike price, it does not need to move as quickly, and implied volatility decreases compared to shorter duration alternatives.
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Source: https://www.thebalancemoney.com/volatility-skew-1-2536780
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