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4.1 Understanding Skew

💡 Advanced Options Concepts

This is where things get complicated, cadet. In this article, you'll learn about:

  • Skewness
  • Skew in statistics
  • Volatility skew in options

Introducing Skewness

Skewness can mean different things in different contexts.

In statistics, skewness is a measure that describes the asymmetry of a distribution around its mean.

In options, we're often referring to the "volatility skew," which describes the variation in implied volatility across different strike prices. The volatility skew becomes especially useful when recognizing mispriced options based on volatility.

Volatility Skew can be used to identify under- or overpriced options based on implied volatility.

Skew in Options

Volatility skew refers to the pattern where options on the same underlying asset with the same expiration date have different implied volatilities based on their strike prices.

First and foremost, let's take a trip down memory lane to illustrate what volatility skew is in practice.

Black Monday (1987): Before the market crash in 1987, implied volatilities were relatively flat across strikes. Post-crash, traders started pricing in a higher probability of catastrophic market declines, leading to higher implied volatilities for out-of-the-money (OTM) puts.

Now, there are multiple types of skew in options: smile, skew, and reverse skew.

Smile: Implied volatility is higher for both deep OTM and deep in-the-money (ITM) options than it is for ATM options.

Skew (or Skewness): Implied volatility is different on one side of the ATM options than the other, typically higher for OTM puts than OTM calls.

Reverse Skew: Implied volatility is higher for OTM calls than for OTM puts.

Importance of Understanding Skew

  • Pricing: Recognizing skew can help traders identify overpriced or underpriced options based on implied volatility.
  • Risk Management: Skew can provide insights into market sentiment and potential tail risks.
  • Hedging: Understanding skew is crucial for those looking to hedge portfolios, as the cost of hedging can vary based on the skew.

Factors Influencing Skew

  • Market Fear: A rush to buy OTM puts as a hedge can drive up their implied volatilities.
  • Supply and Demand: Relative demand for certain strike prices can influence skew.
  • Jump Risk: The market might price in the potential for sudden price movements.
Test Yourself!

What is one of the primary implications of volatility skew in crypto options?

  • Recognizing skew can help traders identify whether or not the implied volatility for an asset is accurate.

  • Recognizing skew can help traders identify overpriced or underpriced options based on implied volatility.

  • Volatility skew can only be used to identify overpriced options.