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Volatility Skew

Trading Term

Volatility skew refers to the pattern in which implied volatility differs across options with the same underlying asset but different strike prices or expirations. In an idealized market, implied volatility should be constant for all options, but in reality, certain strike prices (especially those far out-of-the-money) often show higher or lower volatility. This asymmetry is graphically represented as a “smile” or “skew” on a volatility chart and is influenced by supply and demand, investor sentiment…

Understanding volatility skew is critical for options traders because it affects pricing and risk assessment. For instance, a strong demand for protective puts during uncertain markets can lead to higher implied volatility for lower strike prices, skewing the curve downward. This has direct implications for strategy selection, such as choosing between vertical spreads, straddles, or risk reversals, which may perform differently depending on the shape and direction of the skew.

Volatility skew also provides insight into market expectations. A pronounced skew may indicate heightened fear or anticipation of a market move, particularly to the downside. Institutional investors, such as hedge funds, monitor skew patterns closely to hedge portfolios or detect market inefficiencies. The skew is also affected by macroeconomic factors like interest rates, earnings announcements, or geopolitical events, making it a key analytical tool beyond just pricing mechanics.

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