What is option put skew?
By Simon Gleadall, CEO of Volcube.
Every option has a single implied volatility level associated with it. The implied volatility level affects the value of the option; the higher the implied volatility, in general the higher the option value. Primarily, the implied volatility of an option reflects the amount of volatility that is expected in the price of the underlying product to which the option relates, during the option’s lifetime. So if the underlying product is thought likely to move with a realized volatility level of 20% over the next year, we might expect to see options on this product have implied volatility levels associated with them of close to 20%. However, this is not the whole story. Options of differing strikes but sharing the same underlying and expiration date can have different implied volatility levels. For example, an option whose strike is at-the-money (ie equal to the current spot price) with 3 months before expiry might have an implied volatility level of 20% but a put option expiring at the same time on the same underlying might have an implied volatility level of 30%. In this case, we say there is a skew in the put options.
Why would there be a difference in the implied volatility levels of at-the-money options and put options with strikes below the current spot price? The implied volatility level associated with an option does not only reflect the expected level of actual volatility in the underlying product (or else it would indeed by the same for all options on the same underlying expiring on the same day). Rather, the implied volatility level also reflects the supply and demand for options who only vary in terms of their strike. So if there is a positive put skew and puts are trading at 30% implied volatility levels compared to at-the-money options which are trading at say 20%, then this is because the demand for these puts is higher. Why might the demand be higher? Well, in the case of put options on say stocks or equity indices, a positive put skew might reflect demand from investors looking to hedge their downside risk. There can be a natural bias in the market to prefer downside protection to upside protection (because investors tend to be naturally long the underlying market).
So an ‘options put skew’ refers to the level of implied volatility for options whose strike is below the at-the-money price relative to the implied volatility of at-the-money options or calls (options above the spot price). A positive put skew generally means the puts have higher implied volatility than at-the-money options. Put skew can be ‘flat’ meaning there is no skew at all! Put skew can move; it can become steeper (put implied vol is rising relative to at-the-money implied vol or calls) and it can become shallower. Put skew can also ‘invert’ which generally means it has become negative (i.e. put implied volatilities are lower than at-the-money implied volatilities).
Option put skew can present traders with risks and opportunities. Traders may actively look to ‘trade skew’. For example if they deem the put skew to be too steep and expect it to become more shallow, they may consider selling puts and buying at-the-money options (all delta-hedged). Put skew also affects the gamma/theta profile of options portfolios; high put skews can be associated with poor gamma-to-theta ratios; in other words owning gamma via puts with high skews can be expensive in terms of theta decay compared to a portfolio made up of at-the-money or call options. This is another risk that relates to option put skew.
Volcube is an options education technology company, used by option traders around the world to practise and learn option trading techniques.