What is Vol Skew:
Volatility skew refers to the inequality of the implied volatility of out-of-the-money calls and puts
What Causes Downside Volatility Skew?
In most equities, downside volatility skew is present. Why? Well, most people own stocks in their investment portfolios. There are two very simple and common ways to use options in a long stock portfolio:
1. Purchase out-of-the-money puts to hedge off the risk of a decrease in the stock price (a protective put)
2. Sell out-of-the-money calls to create a potential stream of income on shares of stock without adding any risk (a covered call position).
These two activities cause natural buying pressure in put options and selling pressure in call options, which results in more expensive puts and cheaper calls.
Upside Volatility Skew
Sometimes, we can also see upside vol skew. It happens when the underlying is vol-related product, such as VIX, VXX and other vol ETF.
What Does Volatility Skew Tell You?
There are three useful pieces of information that one can glean from an underlying’s volatility skew:
1. The direction in which the risk is perceived to be in the underlying.
2. How implied volatility will change relative to movements in the underlying.
If you’re trading positive delta, positive vega strategies on a product with upside volatility skew, you’ll know that an increase in the underlying should lead to profits from changes in direction and volatility.
On the other hand, if you’re trading negative delta, negative vega strategies on a product with downside volatility skew, and that underlying falls in price, you can expect some of your directional profits to be offset by an increase in volatility.
3. The prices of call spreads and put spreads on that underlying.
In products with upside volatility skew, call spreads trade cheap and put spreads trade expensive.
In products with downside volatility skew, put spreads trade cheap and call spreads trade expensive.
4. If the vol skew is widening, we can infer the change of investors’ market risk preference,