Volatility Skew: Definition, Example, and Its Role in Portraying Market Sentiment

Understanding market sentiment is crucial for making informed investment decisions. One way to gauge this sentiment is through the concept of volatility skew. Whether you are a seasoned trader or a curious investor, understanding this concept can provide a significant edge. Read on to learn what volatility skew is, how it works, and what its implications are for investors like you.

What is volatility skew?

Volatility skew refers to the pattern observed when the implied volatility of options with the same expiration date but different strike prices is plotted on a graph. Typically, this graph shows that out-of-the-money (OTM) options have higher implied volatilities than at-the-money (ATM) options. This phenomenon is known as the volatility skew.

Volatility skew: An illustration

Consider a stock currently trading at ₹100. If the implied volatility for the ₹90 and ₹110 strike price options is higher than that for the ₹100 strike price option, a skew is present. This skew indicates that investors expect greater price movement in one direction, reflecting underlying market sentiment.

What is implied volatility?

Implied volatility represents the market's expectation of the future volatility of the underlying asset. It is a crucial factor in options pricing and is derived from the market prices of options themselves. Higher implied volatility suggests that investors expect significant price swings, whereas lower implied volatility indicates expectations of relative stability. Understanding implied volatility options can provide insights into market sentiment and potential price movements.

Understanding reverse skew

A reverse skew occurs when the implied volatility of OTM call options is higher than that of OTM put options. This situation typically arises in markets where there is a higher demand for call options, perhaps due to bullish sentiment or expectations of a significant upward price movement. The reverse skew can be a valuable indicator for traders looking to capitalise on expected market rallies.

Understanding forward skew

Conversely, a forward skew is observed when the implied volatility of OTM put options is higher than that of OTM call options. This scenario often occurs in bearish markets or when there is heightened concern about potential downward price movements. The forward skew can signal investor caution and a greater demand for protective puts, which can be useful for hedging strategies.

Implication of volatility skew for investors

The volatility skew has significant implications for investors. It can provide insights into market sentiment, helping investors make more informed decisions about their positions. For example, a pronounced forward skew might indicate that investors are wary of potential downturns, suggesting it could be a good time to consider protective strategies. Conversely, a reverse skew could signal bullish sentiment, indicating opportunities for taking more aggressive positions.

Measuring volatility skew

Measuring volatility skew involves plotting the implied volatilities of options with different strike prices on a graph. The resulting curve can help investors like you understand the market's expectations of future volatility. By regularly monitoring the skew, you can stay attuned to changes in market sentiment and adjust your strategies accordingly.

Volatility skew vs volatility smile – What is the difference?

While volatility skew refers to the asymmetric pattern observed in implied volatilities, a volatility smile describes a U-shaped curve where both OTM call and put options have higher implied volatilities than ATM options. The volatility smile is more common in markets where extreme price movements are expected, but the direction of these movements is uncertain. Understanding the differences between these two patterns can help you better interpret market signals.

Trading with volatility skew

Trading with volatility skew involves leveraging the information provided by the skew to make strategic decisions. For instance, in a market with a forward skew, traders might purchase puts to hedge against potential downturns or sell calls to capitalise on higher implied volatilities. Conversely, in a market with a reverse skew, traders might buy calls to benefit from anticipated upward movements or sell puts to take advantage of higher premiums. By incorporating implied volatility and volatility skew into your strategies, you can enhance your ability to navigate market fluctuations.

Conclusion

Understanding the volatility skew and its implications can provide valuable insights into market sentiment and help you, as an investor, make more informed decisions. Analysing the skew and incorporating it into your trading strategies could help you better navigate the complexities of the financial markets.

Disclaimer: This article is for informational purposes only and does not constitute financial advice. It is not produced by the desk of the Kotak Securities Research Team, nor is it a report published by the Kotak Securities Research Team. The information presented is compiled from several secondary sources available on the internet and may change over time. Investors should conduct their own research and consult with financial professionals before making any investment decisions. Read the full disclaimer here.

Investments in the securities market are subject to market risks, read all the related documents carefully before investing. Please read the SEBI-prescribed Combined Risk Disclosure Document before investing. Brokerage will not exceed SEBI’s prescribed limit.