If you’re still building your arsenal of options knowledge and skill, the concept known as "skew" is an important area of focus.

Skew is the term used in options trading that helps explain why puts generally trade at a higher price than calls - all else being equal.

In a previous blog post, we introduced skew and highlighted how markets tend to crash faster than rally.  That’s why an out of the money put has a higher price than an equidistant out of the money call.

Today, we're going one step further through a discussion on "volatility skew," which was recently featured on an episode of Best Practices.

You may have already noticed when looking across the strikes in a given expiration month that different strikes have different implied volatilities. If skew is "normal," you will see the puts generally trading at a slightly higher implied volatility than calls. A quick look at OTM puts versus OTM calls, this difference should be fairly clear.

Market participants generally "fear" downside risk more than upside risk, which is why demand-supply in the options market creates this "skewed" pricing model. The natural market flow in the options markets also supports this framework, with institutions often protecting their portfolios through put purchases (inflating put prices) and lowering cost basis through call sales (deflating call prices).

Practically speaking, this means that if you see the 20% OTM call trading for a lower absolute implied volatility than the 20% OTM put, that it's not necessarily a "cheaper" option.

Likewise, traders also need to recognize the existence of reverse skew. Gold is a good example of a product that often trades with reverse skew - meaning the calls can trade at richer prices than the puts. The reason for this is that gold prices often rise faster than they decline.

Other examples exist in which the demand for upside calls can be greater than downside puts (reverse skew). In the world of biotechnology, reverse skew can be observed when an upcoming favorable regulatory decision (drug approval) is viewed as highly probable (justified or not).

In my own career, I've also observed reverse skew in Asian markets. In this case, traders seeking delta leverage sell puts instead of buying stock - action that depresses implied volatility on the put side. The plunge in Chinese stock prices during 2015 and 2016 did help correct this imbalance.

As options traders, a valuable "best practice" is to acknowledge the existence of skew and analyze how this reality may help unlock additional opportunity in your portfolio.

On the Best Practices referenced in this post, hosts Tom Sosnoff and Tony Battista outline why certain trading structures make sense for “normal” and “reverse” skew environments. The details from this discussion are illustrated in the graphic below:

 

We recommend you watch the entire episode at your convenience for the best possible understanding of volatility skew.

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Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.