Volatility skew refers to the difference in implied volatility between different strike prices of options contracts for the same underlying asset. This difference in volatility can take on various forms, and understanding these forms can be important for making informed trading decisions. In this article, we will discuss the different types of volatility skews, including horizontal (term structure) and vertical skews.
Vertical skew
First, let’s take a look at vertical skew. Vertical skew, also known as volatility smile or volatility smirk, refers to a difference in implied volatility between options with the same expiration date but different strike prices. The skew is typically upward sloping, with implied volatility increasing as strike price decreases. This is known as a “smile” shape. The reason for this is that options with a lower strike price have a higher probability of expiring in-the-money, and therefore have a higher implied volatility.
Some examples of vertical skews
A stock is currently trading at $100 and the implied volatility for a call option with a strike price of $95 is 15%, while the implied volatility for a call option with a strike price of $105 is 10%. This would be an example of a vertical skew, as the implied volatility is higher for the lower strike price option.
A futures contract for crude oil is currently trading at $50 per barrel and the implied volatility for a call option with a strike price of $47 is 25%, while the implied volatility for a call option with a strike price of $53 is 20%. This would be an example of a vertical skew, as the implied volatility is higher for the lower strike price option.
A currency pair is currently trading at 1.2000 and the implied volatility for a call option with a strike price of 1.1800 is 6%, while the implied volatility for a call option with a strike price of 1.2200 is 4%. This would be an example of a vertical skew, as the implied volatility is higher for the lower strike price option.
Horizontal skew
On the other hand, a horizontal skew, also known as volatility term structure, refers to a difference in implied volatility between options with the same strike price but different expiration dates. The skew can take on different shapes depending on the underlying asset and market conditions. For example, in a bullish market, the skew may be upward sloping, with implied volatility increasing as expiration date increases. This is known as a “backwardation” shape. In contrast, in a bearish market, the skew may be downward sloping, with implied volatility decreasing as expiration date increases. This is known as a “contango” shape.
Some examples of horizontal skews
A stock is currently trading at $100 and the implied volatility for a call option with a strike price of $100 and expiration date in 1 month is 15%, while the implied volatility for a call option with a strike price of $100 and expiration date in 6 months is 20%. This would be an example of a horizontal skew, as the implied volatility is higher for the option with the longer expiration date.
A currency pair is currently trading at 1.2000 and the implied volatility for a call option with a strike price of 1.2000 and expiration date in 1 month is 6%, while the implied volatility for a call option with a strike price of 1.2000 and expiration date in 6 months is 8%. This would be an example of a horizontal skew, as the implied volatility is higher for the option with the longer expiration date.
A futures contract for crude oil is currently trading at $50 per barrel and the implied volatility for a call option with a strike price of $50 and expiration date in 1 month is 15%, while the implied volatility for a call option with a strike price of $50 and expiration date in 6 months is 20%. This would be an example of a horizontal skew, as the implied volatility is higher for the option with the longer expiration date.
How can NinjaSpread help you?
NinjaSpread can help you identify low and high horizontal IV skew underlyings and you can also be alerted when specific conditions are seen in the market.
The most popular strategy to harness horizontal IV skew is using Calendar spreads. Here is an article discussing how to find cheap SPX calendars using NinjaSpread.
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