Flat and steep volatility skew

By roma, 14 August, 2020

Professional option traders very often use terms such as flat and steep volatility skew in conversations. There is no clearly defined rule for calculating the volatility skew, as it will depend on the expiry date and moneyness of options that trader wants to use to determine the skew (Read Rules for Trading Volatility skew).

For example, for short-term options that have an expiration date in 90 days, the volatility skew can be defined as the difference between implied volatility with a strike of 90% and 110% of the forward price of the underlying asset.

Skew = σ90% – σ110%.

Normalized skew = (σ90% - σ110%)/σ100%

For options with a longer expiration date (e.g. 1 year), we can use options with a strike of 80% and 120% of the forward price of the asset to determine the skew level. The key is to choose a strike price range where the price of the asset is highly likely to fluctuate.

 

Flat skew

With flat volatility skew, as described in the example below, the difference between the implied volatility of an option with 90% strike and the volatility of an option with 110% strike is very small. If the skew for Tesla 90-day options is only 100 basis points, this means that a 10% decline in the Tesla stock will not lead to a significant change in the volatility environment - i.e. the stock may fall by 10% (with the same probability as a 10% rise) and ATM options implied volatility will rise by about 100 basis points, depending on the shape of the curve.

As a rule, a flat volatility skew is observed in options for highly volatile stocks with high ATM implied volatility. Since options for highly volatile stocks already have a sufficiently volatile outlook for the stock and a high probability of a 10% price movement over the next 90 days, the implied volatility of options will not change much in the event of such fluctuation. Conversely, if the at-the-money implied volatility is low, we should expect higher implied volatility for lower strike options, as a 10% decline in the share price will be seen by investors as a significant negative event that could lead to further decline (Read Risk reversal: trade volatility skew).

A flat skew (or even inverted skew - where the volatility of OTM call option with high strikes exceeds the volatility of OTM put with low strikes) indicates a strong demand for call options. This scenario is possible when investors are waiting for a merger or acquisition. In the event of takeover, the share price of the acquired company may rise by 20-50%. Therefore the demand for call options with high strikes may increase in anticipation of a merger or acquisition. This will lead to an inversion of the skew, i.e. the implied volatility of high strike call options will be higher than the volatility of low strike put options.

 

Steep skew

Volatility skew

Similar principles apply to steep skew. The chart shows the volatility skew curve for Apple stock options in 2014, where 90%-110% spread is 10% (vs. 1% for Tesla stock), but the volatility of ATM option is approximately the same. In the case of Apple options, investors are concerned about a potential decline in stock, so the increased demand for put options with a lower strike has led to a steeper volatility skew.

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