What is Volatility Skew and How Can You Trade It?

With the emergence of derivatives in the cryptocurrency market, various technical tools are becoming more and more relevant for crypto traders. Probably you have already heard either crypto or traditional market participants discussing the level of volatility skew exhibited. This measure is used by options traders to evaluate options contracts, as volatility is a key variable that affects the options prices.

Key Takeaways

• Volatility skew is a graphical representation of the implied volatility of options with different strike prices.
• Implied volatility (IV) is a measure of how much the market expects an asset's price to fluctuate.
• Volatility skew can be measured with a variety of tools, including the VIX index and volatility cones.
• The most popular strategies are trading vertical skew and horizontal skew, which refer to strike price and expiration dates, respectively.

What is Volatility Skew?

Before we proceed to the volatility skew concept, we need to understand which factors affect volatility. According to the option pricing Black-Scholes model, all options with different strike and expiration dates have the same implied volatility (or IV). This means that the implied volatility does not depend on the option's “moneyness” or expiration date.

However, in practice, the strike price and the expiration date are the major factors which influence implied volatility of options. Thus, the volatility skew is a graph, with the curve reflecting the relationship between the strike price and implied volatility. In other words, it is the difference in implied volatility between “out of the money”, “in the money” and “at the money” options.

The Volatility Smile

The balanced curve on the graph is known as “volatility smile”, as it resembles a smile. It represents the implied volatility for options with the same underlying cryptocurrency with the same expiration date. The strike prices of the options are different.

As we can see in the picture below, the options out-of-the-money (OTM) and in-the-money (ITM) have a higher volatility than the options at-the-money (ATM).

A more common pattern though is asymmetrical and resembles a shifted smile. It is known as “volatility smirk”, or a skew.

What is a Reverse Skew?

Often in long term options, the implied volatility for the options at the lower strikes is higher than for the options with higher strikes. This observed skew is called a reverse skew. It suggests that ITM calls and OTM puts are more expensive compared to OTM calls and ITM puts.

Reverse skew results from investors buying put options in order to compensate for the risk associated with cryptocurrency, especially when they perceive a market crash.

What is a Forward Skew?

An opposite situation may occur, when lower strikes have a lower implied volatility than options with higher strikes. This observed skew is called a forward skew. It suggests that OTM calls and ITM puts are in greater demand compared to ITM calls and OTM puts.

Volatility Skew Example

Bitcoin recent recovery stirred up enthusiasm among crypto traders. Consistent with the positive sentiment, bitcoin options’ volatility skew shows that the demand for OTM calls is increasing. On the graphs below, we can clearly see how reverse skew has shifted toward a more balanced smile. We also see that the strike price people are willing to pay for has increased. The skew is “reflecting an increase in demand for exposure to upwards movements”, as Block Scholes analyst noted.

What is Implied Volatility (IV)?

Let’s revisit the concept of implied volatility and elaborate on how it relates to option contracts.

Volatility in the broad sense is a measure of fluctuations in the price range of the underlying asset. Implied volatility (IV) is a market forecast of the likely price movement of a cryptocurrency. It is used by investors to estimate future fluctuations in the price of the cryptocurrency based on certain predictive factors. Investors can use this forecast as an indicator when making investment decisions.

Implied volatility is denoted by the symbol σ, and is expressed as a percentage and standard deviations over a specific time period. It is calculated using the Black-Scholes option pricing model.

The Effects of "Black Monday"

Before the 1987 stock market crash which affected every major stock market in the world, OTM call options traded at the same price as OTM put options. But after Black Monday, traders realized that they needed to protect their positions, and put options became much more valuable than calls. The fear associated with a big drop in the markets is a stronger motivator than the feeling of euphoria amid strong growth. Investors tend to be willing to overpay to protect their existing investments.

However, there may be times when call options become more valuable than their put equivalents. This is called reverse skew and can occur during unusually strong upward movements in the market.

What Does Volatility Skew Mean for Investors?

Volatility skew is commonly used as a tool to assess whether traders are willing to pay more or less for an option depending on different strike prices or expiration dates.

There are certain patterns that are expected to manifest in volatility skew. The volatility skew deviating from these expectations usually signals an impending significant change in the price of the underlying cryptocurrency. Traders use these deviations from normal patterns to predict price movements in both the underlying cryptocurrency and options on it.

How Do You Measure Volatility Skew?

Volatility skew is measured by plotting points with different implied volatility of strike prices on the chart. For example, a trader may view a list of buy/sell prices of option contracts for a particular asset that expire on the same date. The average points of implied volatility from the buy/sell prices are plotted on the chart.

How Do You Trade With Volatility Skew?

While trading volatility skew it is important to pay attention on situations when the curve on the chart becomes asymmetrical. Such asymmetry is called a "volatility smirk" and it can be observed both to the right and to the left. The slope of the smile's edge is called "volatility skew".

The shape of the smile can tell you in which direction the price is moving. Also, pay attention to the magnitude of the curve which indicates the strength of the expected movement. The market players expect more movement of quotations in that direction, in which the smile is shifted.

If a sharper drop in price is expected, the implied volatility of OTM put options will be greater than that of OTM call options. In this case, the left side of the curve will be elevated relative to the right side, so that we will see a smirk shifted to the left on the chart.

Another type of option volatility smirk is the smirk to the right. It indicates that traders are expecting a sharp upward movement in the price of the underlying asset. Such a smirk can be used as a signal to buy the asset.

Thus, the volatility curve is quite an informative indicator of trader sentiment and can be a good addition to the technical analysis.

Horizontal Skew

Horizontal, or time skew, refers to options with the same strike price, but different expiration dates. A forward (or positive) horizontal skew occurs when volatility of options with the nearest expiration is higher than expected. The option contracts will be more expensive then.

A reverse (or negative) horizontal skew occurs when volatility of options with more far-off expirations is higher. In this case, traders will be willing to buy the options with the nearest expiration and sell the longer-term options.

Horizontal volatility skew is affected by economic crises, regulatory tightening and other important events that cause market sentiment to change, and implied volatility may increase while horizontal skew may flatten.

Where there is implied volatility in the horizontal skew, there may also be inefficient pricing that traders can take advantage of.

Vertical Skew

Trading with a vertical skew is easier than trading with a horizontal skew. Vertical skew or just volatility skew reflects the difference between the implied volatility of different strike prices of options with the same expiration date.

Thus, using vertical asymmetry, traders can find opportunities to trade debit and credit spreads, finding the best strike prices to buy or sell.

Conclusion

The volatility skew appeared due to the 1987 market turmoil. After Black Friday traders were forced to reconsider their trading strategies and pay more attention to hedging portfolios against a sharp collapse in asset prices.

Volatility skew is influenced by sentiment and the supply/demand ratio of specific options in the market. Thus, the graph with the skew provides information on whether option sellers prefer to write “call” or “put” options.

Understanding certain patterns of volatility skew helps traders use this phenomenon to predict price movements of both the underlying cryptocurrency and options on it. Because of this, volatility skew is a good indicator of trader sentiment and can be used in addition to technical analysis.

Frequently Asked Questions (FAQs)

How Do You Trade Using the Volatility Skew?

Traders look at the shape of the curve to make decisions. Suppose the curve becomes asymmetrical and the “volatility smile” turns into a “volatility smirk”. Such change may indicate an increased risk of a price movement of the underlying asset in a certain direction. The magnitude of the curve slope will inform you about the strength of the movement.

Why Is Volatility Skew Steeper for Options That Expire in the Near Term?

Volatility skew is often steeper for options that expire in the near term because they are more sensitive to upcoming market events, such as earnings reports or major political events. Typically, these options are perceived to be risky, which leads to a higher implied volatility and a steeper skew. As options contracts move further out in time, the impact of these events becomes less significant, resulting in a flatter skew.

*This communication is intended as strictly informational, and nothing herein constitutes an offer or a recommendation to buy, sell, or retain any specific product, security or investment, or to utilise or refrain from utilising any particular service. The use of the products and services referred to herein may be subject to certain limitations in specific jurisdictions. This communication does not constitute and shall under no circumstances be deemed to constitute investment advice. This communication is not intended to constitute a public offering of securities within the meaning of any applicable legislation.