Volatility Skew: How it Can Signal Market Sentiment

The volatility skew is the difference in implied volatility (IV) between out of the money options (OTM), at the money options (ATM) and in the money options (ITM). The volatility skew, which is affected by sentiment and the supply and demand relationship of particular options in the market, provides information on whether traders and investors prefer to write calls or puts.

Also known as a vertical skew, traders can use relative changes in skew for an options series as a trading strategy.

Why Would Volatility Skew?

Volatility skew occurs due to the difference in implied volatility (IV) levels of options with different strike prices but the same expiration date. The IV of an option is a measure of how much the market expects the price of the underlying asset to move.

The primary driver of volatility skew is the collective expectations and behavior of market participants. If investors expect a significant price movement in one direction, these investors may be willing to pay more for options that would profit from that move. This increased demand can drive up the IV of those options, creating a skew.

Also, investors often perceive downside risk, that is, the risk of prices falling as greater than upside potential, particularly in equity markets. This is because stock prices can only go to zero, but there's theoretically no limit as to how much they can rise. As a result, investors are often willing to pay more for put options which increase in value when prices fall, than for call options, which increase in value when prices rise. This can result in higher IV for OTM put options, creating a volatility skew.

Additionally, certain market events, such as earnings announcements or economic reports, can also create a volatility skew. If investors expect these events to cause significant price movements, they may be willing to pay more for options that would profit from those movements. This can create a temporary volatility skew that disappears after the event.

Indeed, events such as major market downturns or financial crises can lead to volatility skews. For example the 1987 stock market crash led to a significant volatility skew as investors rushed to buy put options to protect against further declines.

The shape of the volatility skew can provide valuable information about market expectations and potential future price movements. However, it's important for traders and investors to remember that these are just expectations, and actual future price movements may be different.

The Interpretation of a Volatility Skew

Interpreting a volatility skew involves understanding the implications of the shape and slope of the skew. Some interpretations of the volatility skew include:

• Positive or Forward Skew: If the skew is positive, it means that OTM call options have a higher implied volatility than OTM put options. This is often seen in commodities markets where a sudden demand spike can lead to significant price increases. A positive skew suggests that the market is expecting an upward price movement.
• Negative or Reverse Skew: If the skew is negative, it means that OTM put options have a higher implied volatility than OTM call options. This is often seen in equity markets where investors are more concerned about price drops and hence are willing to pay more for put options to protect their investments. A negative skew suggests that the market is expecting a downward price movement.
• Smile: If the implied volatility is higher for both OTM call and put options compared to ATM options, it creates a "smile" shape. This is often seen in markets with high uncertainty or expected large price movements in either direction.
• Flat or No Skew: If there is no skew, it means that the IV is the same for all options, regardless of the strike price. This suggests that the market does not expect significant movements in either direction.

It should be noted that the volatility skew is based on market expectations, which can change over time. Therefore, it's important for investors and traders to continually monitor the skew and adjust their respective strategies accordingly. Also, the skew should be used in conjunction in with other market indicators.

Determining Abnormal Volatility

A volatility skew can be used to identify abnormal volatility in the market. A significant change in the volatility skew can indicate abnormal volatility. One example entails when the skew becomes more negative, that is, the IV of OTM put options increase relative to call options, it could suggest that investors are expecting a significant downward price movement, which would likely be accompanied by increased volatility.

Also, by comparing the current volatility skew to its historical levels, traders and investors can identify if the current market expectations reflected in the skew are abnormal. If the skew is significantly different from its historical average, it could suggest that the market is expecting abnormal volatility.

Furthermore, a volatility smile, where the IV is higher for both OTM and ITM options compared to ATM options, can indicate that the market is expecting large price movements in either direction. This suggests abnormal volatility.

Another note is if the implied volatility varies significantly across different strike prices, that is, the skew is steep, it could suggest that the market is experiencing abnormal volatility.

While volatility skew can provide valuable insights into market expectations, it should not be used in isolation. Other factors, such as market news, economic indicators, and even other technical analysis tools, should be considered when assessing the likelihood of abnormal volatility.

The Formation of a Volatility Smile

A volatility smile means that the IV of options on a particular underlying security or market index increases as the options become further ITM or OTM, with the lowest point generally occurring ATM. The pattern is often depicted as a V-shaped curve.

The Implications of a Volatility Smile

A volatility smile has several important implications for options pricing and market expectations. They are as follows:

• Market Expectations: The volatility smile reflects market expectations of future price movements. If the smile is steep, that is, the IV of ITM and OTM options is significantly higher than ATM options, it suggests that the market is expecting large price movements.
• Pricing of Options: The volatility smile can affect the pricing of options. Options with strike prices in the "wings" of the smile, that is, far ITM or OTM will have higher IVs and therefore will be more expensive than if the IV was flat across all strike prices.
• Risk Assessment: The shape of the volatility smile can provide information about the perceived risk in the market. A steep volatility smile might suggest that the market is perceiving a higher risk of large price movements.
• Arbitrage Opportunities: In theory, options on the same underlying asset with the same expiration date but different strike prices should have the same IV. If this is not the case, as indicated by the volatility smile, it could potentially create arbitrage opportunities. However, these opportunities are often difficult to exploit in practice due to transaction costs and other market frictions.
• Jump Risk: A pronounced volatility smile can indicate a market expectation of "jump risk", or the risk of large, sudden price movements. This could be due to upcoming events like earnings announcements, economic reports, or other market- moving news.
• Limitations of Black-Scholes Model: The existence of a volatility smile is often seen as evidence of the limitations of the Black-Scholes model for options pricing, which assumes that volatility is constant and does not change with the strike price. The volatility smile suggests that this assumption does not hold in the real world.

The Formation of a Volatility Smirk

A volatility smirk occurs when IV for options on an underlying security or index decreases as the options become more deeply ITM or OTM. The pattern is often depicted as a curve that slopes downward, resembling a smirk.

The Implications of a Volatility Smirk

A volatility smirk has several implications for options pricing, market expectations, and risk management. This include:

• Market Expectations: The volatility smirk reflects market expectations of future price movements. If the smirk is steep, that is, the IV of OTM put options is significantly higher than ATM or ITM options, it suggests that the market is expecting a significant downward price movement.
• Pricing of Options: Options with strike prices in the "tail" of the smirk, that is, far OTM put options will have higher IVs and therefore will be more expensive than if the volatility was flat across all strike prices.
• Risk Assessment: The shape of the volatility smirk can provide information about the perceived risk in the market. A steep volatility smirk might suggest that the market is perceiving a higher risk of large price movements, particularly to the downside.
• Arbitrage Opportunities: In theory, options on the same underlying asset with the same expiration date but different strike prices should have the same IV. If this is not the case, as indicated by a volatility smirk, it could potentially create arbitrage opportunities. However, these opportunities are often difficult to exploit in practice due to transaction costs and other market frictions.
• Jump Risk: Similar to a volatility smile, a pronounced volatility smirk can indicate a market expectation of "jump risk". This could be due to upcoming events like earnings announcements, economic reports, or other market-moving news.
• Limitations of Black-Scholes Model: The existence of a volatility smirk is often seen as evidence of the limitations of the Black-Scholes model for pricing options, which assumes that volatility is constant and does not change with the strike price. The volatility smirk suggests that this assumption does not hold in the real world.

The Benefits and Limitations of Analyzing Volatility

Analyzing volatility in the financial markets can provide several benefits but as with any form of analysis or technique, there are limitations.

The Benefits of Analyzing Volatility

Volatility is a key measure of risk in financial markets. Higher volatility typically indicates higher risk, as it suggests larger potential price swings. This can help investors assess the riskiness of different assets or portfolios.

Also, by understanding the volatility of different assets, investors can better diversify their portfolios. Assets with low correlation and different volatility levels can provide diversification benefits. Indeed, volatility is a crucial input in the pricing of derivatives, such as options. Higher volatility generally leads to higher option prices.

Furthermore, changes in volatility can provide market insights into market sentiment. For example, rising volatility may indicate increasing uncertainty or fear among market participants. Traders and investors alike use volatility to inform their investment strategies. They may use strategies such as straddles or strangles in a high-volatility environment.

The Limitations of Analyzing Volatility

Some limitations with analyzing volatility include the calculation of volatility, the stability of volatility, the normal distribution assumption, volatility clustering and the lack of direction in volatility analysis.

Historical volatility, calculated from past price changes, may not accurately predict future volatility. Implied volatility, derived from option prices, can provide a forward-looking estimate but is based on market participants' expectations, which may not always be accurate.

Indeed, volatility itself can be volatile. It can change rapidly in response to market events, making it difficult to predict. Moreover many models that use volatility assume that price changes follow a normal distribution. However, in reality, financial returns often exhibit skewness and kurtosis, meaning that they have asymmetric and fat-tailed distributions.

Also, financial markets often exhibit volatility clustering, where periods of low volatility tend to be followed by periods of high volatility, and low volatility periods are followed by high volatility. This complicates the analysis.

Finally, volatility measures the magnitude of price changes, but it does not provide any information about the direction of the change. High volatility could mean large price increases, large price decreases or a mixture of both.

The Bottom Line

Analyzing volatility provides insights into market sentiment and potential price movements, aiding in risk management and trading strategy development. It can be analyzed through various methods such as historical volatility, implied volatility, volatility indices, GARCH models, and more. However, it's important to note that while these methods can provide valuable insights, none of them can perfectly predict future volatility. They should be used as tools to help inform decision-making, not as definitive predictors of future outcomes. The limitations of analyzing volatility include the fact that it's based on past data and market sentiment, which may not accurately predict future market conditions. Additionally, high volatility can indicate higher risk, which may not be suitable for all investors.