Options trading is a game of probabilities, pricing inefficiencies, and risk management. While most traders focus on implied volatility (IV) as a singular number, professional traders understand that not all strikes are priced equally. This pricing discrepancy, known as volatility skew, presents opportunities for those who know how to exploit it.
By mastering volatility skew, traders can identify mispriced options, structure better risk-reward trades, and gain a strategic edge in the market. This guide breaks down what volatility skew is, why it exists, and how to use it to enhance trading performance.
What is Volatility Skew?
Volatility skew refers to the difference in implied volatility across different strike prices or expiration dates for the same underlying asset. In an ideal world, implied volatility would be consistent across all strikes. However, in reality, IV varies based on market demand, risk perceptions, and institutional positioning.
There are two primary types of skew:
- Vertical Skew (Strike-Based Skew) – The variation of IV across different strike prices for the same expiration.
- Horizontal Skew (Term Structure Skew) – The variation of IV across different expiration dates.
Both skews can create pricing inefficiencies that traders can exploit through well-structured option strategies.
Types of Volatility Skew and Why They Exist
1. Reverse Skew (Put Skew) – The Default in Equity Markets
Most stocks exhibit a put-side volatility skew, meaning that put options have higher implied volatility than calls. This phenomenon exists because:
- Investors hedge downside risk – Institutions buy put options to protect portfolios, increasing demand and raising IV.
- Market makers offset risk – Since market makers often sell puts, they increase IV to compensate for potential tail-risk losses.
- Fear escalates faster than greed – Market crashes are sudden and sharp, while rallies tend to be more gradual.
How to Trade It:
- Selling puts (cash-secured puts or put spreads) allows traders to benefit from inflated IV.
- Buying calls on strong stocks can be more cost-efficient than buying puts.
- Risk-reversal trades (long call, short put) can exploit skew by reducing net premium costs.
2. Forward Skew (Call Skew) – Common in Commodities & Meme Stocks
Certain assets exhibit a call-side volatility skew, meaning that calls have higher implied volatility than puts. This is more common in:
- Commodities (oil, gold, natural gas) – Since supply shocks can cause rapid price increases, traders demand upside protection, inflating call IV.
- Meme stocks and speculative assets – Retail-driven momentum can lead to extreme upside speculation, raising call IV disproportionately.
How to Trade It:
- Selling call credit spreads in overheated markets can take advantage of inflated call IV.
- Buying put spreads offers cheaper downside hedging when call skew is extreme.
- Diagonal spreads (long call, short further OTM call) can exploit call skew by collecting premium from overvalued OTM options.
3. Flat Skew – Market Equilibrium
In some cases, volatility is relatively uniform across strikes, meaning there is no strong bias in either direction. This is more common in:
- Stocks with low speculation or low liquidity.
- Periods of market calm when traders aren’t aggressively hedging or speculating.
How to Trade It:
- Iron condors and straddles work well since both puts and calls are fairly priced.
- Long volatility strategies (straddles, strangles) are attractive if implied volatility is low.
4. Time-Based Volatility Skew (Term Structure Skew)
IV also varies across different expiration dates. In normal markets:
- Near-term expirations tend to have lower IV due to lower uncertainty.
- Longer-term options carry higher IV because more time means more potential movement.
However, event-driven scenarios can invert the term structure, causing near-term options to be more expensive than long-term ones.
Common Causes of Inverted Skew:
- Earnings reports – Near-term IV spikes before earnings, then collapses after.
- Upcoming news catalysts – FDA approvals, Fed decisions, or economic data releases.
- Market crashes – Traders rush to hedge short-term uncertainty, raising front-month IV.
How to Trade It:
- Earnings trades: Buying straddles or selling volatility (calendar spreads) to exploit IV crush post-event.
- Event-driven trades: Long calendars (long back-month, short front-month) to profit from reversion of term structure.
- Crash protection: Buying longer-term hedges (LEAPS puts) instead of short-term options.
How to Use Volatility Skew to Your Advantage
1. Sell Options Where IV is Overstated
Since put options usually have higher IV, selling puts or put spreads can take advantage of this pricing premium. Conversely, when calls are overpriced (such as in speculative rallies), selling calls or call spreads can generate strong risk-adjusted returns.
Example:
- A stock trades at $100, with the $90 put IV at 40% and the $110 call IV at 25%.
- Selling a bull put spread ($90/$85) provides a higher risk reward than selling a bear call spread.
2. Buy Options Where IV is Understated
If implied volatility is unusually low for a particular strike, it can indicate underpriced movement potential. This is particularly useful when:
- Call IV is lower than put IV, yet the stock has bullish momentum.
- IV across expirations is too low despite upcoming catalysts.
Example:
- A biotech stock is trading at $50, with an FDA decision expected next month.
- The current IV is low, meaning options are cheap.
- Buying a long straddle or long call can capitalize on the potential volatility spike.
3. Structure Trades to Exploit Skew Asymmetry
If a stock has a steep put skew, traders can use risk-reversals instead of outright long positions.
Example:
- A stock is trading at $200, and the $190 put IV is 50%, while the $210 call IV is 30%.
- Instead of buying the stock outright, a trader could sell the put and buy the call, creating a zero-cost bullish exposure.
4. Adjust Strategies Around Event-Driven Skew
Understanding how IV shifts around earnings and news events can help traders position early.
Example:
- A stock has an earnings report next week.
- Front-month IV is elevated, while next-month IV is more stable.
- Selling a calendar spread (short front-month, long back-month) profits when IV collapses post-earnings.
Final Thoughts: Gaining an Edge Through Volatility Skew
Volatility skew is often overlooked by retail traders, but it plays a critical role in option pricing. By understanding how and why skew forms, traders can:
- Identify overpriced and underpriced options to structure smarter trades.
- Capitalize on event-driven opportunities where IV is mispriced.
- Improve trade selection by aligning with market sentiment and risk positioning.
Mastering volatility skew isn’t just about knowing it exists-it’s about actively using it to enhance returns, minimize risk, and find hidden edges in the options market.