April Webinar Key Takeaways: Understanding Volatility and Options Skew

In April, OIC instructor Ken Keating led two webinars: Volatility 101: Learning to Read Market Uncertainty and Reading Between the Strikes: Understanding Options Skew. These sessions formed a two-part series on implied volatility—first establishing how volatility is measured and what it means for options pricing, then examining how implied volatility varies across strikes and expirations through the concept of skew.

Together, the webinars provided a framework for reading market uncertainty, interpreting the VIX, and using volatility analysis—including skew—to make more informed strategy decisions.

What We Covered:

Volatility and Its Effect on Options Prices

Volatility reflects the expected magnitude of price movement in the underlying asset—in both directions and across any time horizon. It carries no directional bias.

• Higher expected movement leads to higher option prices; lower expected movement leads to lower prices.
• This relationship holds for both calls and puts simultaneously.
• Volatility affects the extrinsic, or time value, component of an option’s premium.
• Intrinsic value is unaffected by changes in implied volatility.

Historical vs. Implied Volatility

Two distinct types of volatility were examined:

• Historical Volatility (HV) is a backward-looking statistic calculated from actual past price movements. It describes how volatile a stock has been over a given period and is a fact, not a forecast.
• Implied Volatility (IV) is forward-looking. It is derived from current option prices and reflects the market’s collective expectation of future price variability between now and expiration.
• Only options have implied volatility—stocks do not.
• Implied volatility does not necessarily revert to a stock’s historical volatility level.
• Changes in implied volatility directly affect the market value of options positions, even when the underlying price remains unchanged.

The VIX: Definition, Calculation, and Interpretation

The CBOE Volatility Index (VIX)—often called the “Fear Index” or “Fear Gauge”—measures the 30-day forward implied volatility of the S&P 500, derived from SPX option prices. Created by the CBOE in 1993, it is calculated by selecting near-term and next-term SPX options with expirations between 23 and 37 days, filtering for out-of-the-money puts and calls with non-zero bid prices, and interpolating to a constant 30-day expected volatility expressed as an annualized percentage.

A VIX of 20 implies approximately 20% annualized volatility, or roughly 1.25% expected daily movement. The Rule of 16 allows traders to convert that annualized figure into a daily or weekly expected move. VIX levels can be categorized as follows:

• 0–12: Low volatility. Markets are calm and often complacent.
• 12–20: Normal range. Healthy market conditions with moderate uncertainty.
• 20–30: Elevated concern. Heightened market anxiety.
• 30–40: High fear. Significant stress, typically seen during sharp sell-offs.
• 40+: Extreme fear. Panic territory seen in major crises such as the 1987 market crash, the great financial crisis of 2008, and COVID.

The VIX is inversely correlated to the S&P 500 and tends to rise faster during sell-offs than it falls during rallies. It measures the expected magnitude of potential moves—not direction. The VIX cannot be traded directly but can be accessed through VIX options or futures.

Volatility Metrics: IV Rank and IV Percentile

A standalone implied volatility reading lacks context without knowing where it sits relative to its own history. Two normalizing metrics help address this:

• IV Rank (IVR) measures where current implied volatility sits within its own 52-week range. A reading of 0% indicates IV is at its annual low; 100% indicates it is at its annual high. Formula: IVR = (Current IV – 1-Year Low) ÷ (1-Year High – 1-Year Low).
• IV Percentile (IVP) measures the percentage of days over the prior year that implied volatility traded below the current level. An IVP of 80% means implied volatility has been lower than it is today 80% of the time, indicating options are currently expensive on a historical basis.
• Both metrics allow traders to determine whether implied volatility is historically elevated or inexpensive and to align their strategy selection accordingly.
• Because implied volatility is mean-reverting over time, options tend to perform better when strategies account for where IV stands relative to its history.

What Is Options Skew?

Option skew refers to the asymmetrical implied volatility observed across options with different strike prices but the same expiration date. Rather than a flat volatility surface—as assumed under the original Black-Scholes model—market-implied volatility varies across strikes. When these implied volatilities are charted across all strikes and expirations, they form what is known as the volatility surface.

• Skew is ultimately a function of supply and demand.
• It is dynamic and moves throughout the trading day.
• Skew can be both positive and negative depending on which directional tail is in greater demand at any given time.
• Some traders view skew as a sentiment indicator reflecting which direction the market is pricing more risk.

The History of Skew: Before and After 1987

Before October 1987, options markets largely priced in accordance with Black-Scholes, which assumed constant volatility across strikes—a flat volatility surface. There was no persistent skew pattern. The market crash of 1987, when the Dow fell nearly 23% in a single session, fundamentally changed this:

• Out-of-the-money put prices surged as investors sought portfolio protection.
• Market makers demanded a higher premium for selling deep out-of-the-money puts to compensate for the risk they were assuming.
• The volatility “smirk”—where downside puts carry higher implied volatility than equidistant upside calls—became a structural feature of equity index options.

The pre-1987 flat volatility surface has never returned. Skew has been a permanent and constant feature of options markets ever since, as it prices in the reality that markets tend to fall harder and faster than they rise.

Types of Skew: Negative, Positive, and Smile

Three skew profiles were presented:

• Negative Skew (Put Skew): Out-of-the-money puts carry higher implied volatility than equidistant out-of-the-money calls. This is the dominant pattern in equities, ETFs, and indexes, reflecting the premium investors pay for downside crash protection. The chart of this relationship resembles a smirk, not a smile, as the downside slopes steeply higher while the upside rises only modestly.
• Positive Skew (Call Skew): Out-of-the-money calls carry higher implied volatility than out-of-the-money puts. More common in certain commodities where demand shock to the upside is the primary risk. Also observed in the VIX index itself, as VIX calls benefit when markets sell off.
• Smile Skew: Both out-of-the-money puts and out-of-the-money calls carry higher implied volatility than at-the-money options, forming a U-shaped or smile profile. This appears in markets where risk is perceived in both directions—for example, a biotech stock facing a binary FDA decision with large potential moves to either the upside or the downside.

Why Skew Exists: Supply and Demand

Three structural forces drive skew in equity and index options:

• Hedging: Investors who are long assets hedge their exposure without selling by buying protective puts or selling out-of-the-money calls. This combination—known as a collar—creates natural, persistent demand for downside puts and supply of upside calls.
• Inverse correlation: Because markets tend to fall faster and harder than they rise, investors pay a premium for out-of-the-money puts as protection against sudden sell-offs, driving put implied volatility higher relative to the corresponding calls.
• Supply and demand imbalance: Systematic put buying and call selling pushes put implied volatility higher and call implied volatility lower over time, embedding the skew as a structural feature of the options market.

Term Structure and Skew

The at-the-money volatility term structure describes how implied volatility varies across expiration dates, independent of strike. Three states were examined:

• Contango (Normal): Longer-dated implied volatility exceeds shorter-dated implied volatility. The curve slopes upward to the right, reflecting uncertainty compounding over time and the mean-reverting nature of volatility from a low base. Typical in calm, low-volatility markets.
• Backwardation (Inverted): Short-dated implied volatility exceeds longer-dated implied volatility. The curve slopes downward to the right. Common during periods of stress and fear—as seen during the recent Iran-related market volatility—and during events such as COVID and the 1987 market crash.
• Event-driven spikes: Earnings announcements, FOMC decisions, elections, and other known catalysts can create isolated volatility spikes at specific expirations, distorting the otherwise smooth term structure.

Measuring and Tracking Skew

Four practical methods for quantifying skew using Delta-based comparisons were presented:

• Price of the Risk Reversal: 25 Delta Put Price – 25 Delta Call Price. Expresses skew in dollar terms. In a product with negative skew, the put will trade at a premium to the call. This price differential is the “risk reversal” value and is quoted by market makers as a bid-offer spread around fair value.
• Volatility Ratio (Put/Call): 25 Delta Put IV ÷ 25 Delta Call IV. Takes price out of the equation and compares implied volatility levels directly. A ratio greater than 1.0 indicates negative skew; the higher above 1.0, the steeper the skew. This ratio can be tracked historically to assess whether current skew levels are elevated or compressed.
• Call Skew Ratio: 50 Delta Call IV ÷ 25 Delta Call IV. Measures the slope on the call side of the volatility surface. In a negative skew environment, the at-the-money call will carry higher implied volatility than the out-of-the-money call, producing a ratio above 1.0.
• Put Skew Ratio: 50 Delta Put IV ÷ 25 Delta Put IV. Measures the slope on the put side. In a negative skew environment, the 25 Delta put carries higher implied volatility than the at-the-money put, so this ratio will typically be below 1.0. The further below 1.0, the more steeply the downside is being priced.

The 25 Delta option is the conventional reference point for skew analysis because it sits at a meaningful midpoint between at-the-money and deep out-of-the-money options. Options at very low Deltas—such as 5 or 10 Delta—have such small absolute premiums that small price changes produce large implied volatility swings, making their vol levels difficult to interpret in context.

Key Structural Insights

• Implied volatility drives the extrinsic value of an option and affects both calls and puts simultaneously and in the same direction.
• Historical volatility is a backward-looking metric about the stock; implied volatility is a forward-looking market expectation embedded in options prices—the two do not necessarily converge.
• The VIX is a real-time sentiment gauge measuring the 30-day expected S&P 500 volatility; it has no directional bias and tends to mean-revert over time toward its long-term average of approximately 18–20.
• IV Rank and IV Percentile normalize current implied volatility against its own history, enabling more informed decisions about whether options are cheap or expensive and which strategies may be better suited to the environment.
• Skew is a permanent structural feature of equity and index options markets, born from the market crash of 1987 and sustained by the persistent supply-and-demand dynamics of institutional hedging.
• The type of skew—negative, positive, or smile—reflects the market’s view of directional risk in a given product and can be tracked using Delta-based price and volatility ratios to inform strategy selection and strike targeting.

Keep Learning:

Key Moments from Volatility 101: Learning to Read Market Uncertainty
Key Moments from Reading Between the Strikes: Understanding Options Skew

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