Volatility and Skew: The Hidden Forces of Options Markets
Volatility and skew are the invisible forces that drive options pricing. Understanding them gives you a significant edge in the options market.
Key Concepts
- How to read and interpret volatility signals
- Why some options are more expensive than others (skew)
- How to trade volatility for profit
Understanding Volatility
Volatility measures how much a stock price fluctuates. In options trading, we care about two types:
Historical Volatility (HV)
This is the actual measured volatility of the stock over a past period.
- Higher HV = Larger past price swings
- Common periods: 10-day, 30-day, 90-day
- Used to compare with current IV levels
Example: HV vs IV Analysis
If 30-day HV is 20% but 30-day IV is 30%:
- Options might be overpriced (IV > HV)
- But upcoming earnings could justify higher IV
Implied Volatility (IV)
This is the market's forecast of future volatility, derived from option prices.
- High IV = Expensive options
- Low IV = Cheap options
- IV tends to mean-revert over time
Important IV Concepts
- Options lose value even if stock doesn't move
- Buying high IV options can be risky
Term Structure: Volatility Across Time
Term structure shows how IV varies across different expiration dates.
Term Structure Patterns
- Normal: Upward sloping (longer-dated = higher IV)
- Inverted: Short-term IV higher than long-term
- Flat: Similar IV across expirations
Trading Insight
Normal term structure suggests calendar spreads might work
Volatility Skew: Volatility Across Strikes
Skew shows how IV varies across different strike prices for the same expiration.
Key Skew Concepts
- Wings: OTM options often have higher IV than ATM
- Symmetry: Put wing vs Call wing differences
- Steepness: How quickly IV changes between strikes
Common Skew Pattern
Put wing steeper than call wing (typical for stocks)
Why Does Skew Exist?
Skew exists because market participants value downside protection more than upside potential. This creates the classic reverse skew pattern.
Trading Volatility and Skew
How to use volatility and skew knowledge in your trading:
- Consider selling premium (Iron Condors, Credit Spreads)
- Look for skew opportunities (Risk Reversals)
- Use calendar spreads if term structure is steep
Example Strategy: Iron Condor
- Collect premium when IV is high
- Risk of large moves breaking through wings
Volatility Checklist Before Trading
Before placing a trade, check:
- Current IV vs Historical IV
- Term structure shape
- Skew levels
- Upcoming events