Volatility Skew

Volatility Skew is a complex options pricing concept.  I’m going to explain what volatility skew means, so you can understand why certain options end up priced the way they are.

Here’s the deal…

Volatility skew explains why deep out of the money (OTM) option will tend to have higher implied volatility than an at the money (ATM) option. Here’s an example…

You’re looking through an options chain on a particular stock, and you see that a deep OTM option showing a value of $0.01, with a very high implied volatility.

Your initial reaction would be to question why an option so far OTM has any value at all… and why it would carry such high implied volatility.

The answer is this…

The deep OTM option has value because the options market maker must have some value assigned to options OTM… even if the stock has low chance of ever reaching the strike.  And the abnormally high implied volatility can be explained quite easily…

Here’s the thing, if anyone were to buy the option… in most cases it would jump from $0.01 to $0.02.  And that would be 100% movement.  On the flip side, if no one ever bought the option for .01 and it expired without value… option would drop from $0.01 to 0.00!  The move would also be 100%.

The bottom line is this…

For traders with options strategies focused on buying and selling volatility… volatility skew is important.  Implied volatility is skewed in deep OTM options, and they’re purchased usually due to various hedging strategies.

Category: Options Trading Basics