Volatility Skew

Volatility skew is a term used to describe the relationship between the implied volatility of an option and its strike price. In other words, it is a measure of how the implied volatility of an option changes as the strike price changes.

Volatility skew can be positive or negative. A positive volatility skew means that the implied volatility of an option is higher for out-of-the-money strikes than for in-the-money strikes. A negative volatility skew means that the implied volatility of an option is lower for out-of-the-money strikes than for in-the-money strikes.

Volatility skew can be caused by a number of factors, including:

• The time to expiration of the option.
• The underlying asset's volatility.
• The liquidity of the option.
• The market's expectations about future volatility.

Volatility skew can be an important factor to consider when trading options. It can help traders to identify opportunities to profit from mispriced options.

Here are some examples of how volatility skew can be used to trade options:

• A trader who believes that the underlying asset's volatility will increase may buy an out-of-the-money call option with a positive volatility skew. This is because the higher implied volatility of the out-of-the-money call option will offset the lower strike price, resulting in a higher potential profit if the underlying asset's price increases.
• A trader who believes that the underlying asset's volatility will decrease may sell an out-of-the-money put option with a negative volatility skew. This is because the lower implied volatility of the out-of-the-money put option will offset the higher strike price, resulting in a higher potential profit if the underlying asset's price decreases.

Volatility skew is a complex concept, and it is important to understand how it works before using it to trade options. However, volatility skew can be a powerful tool for option traders who are willing to take the time to learn how to use it.