Volatility skew refers to the unevenness or asymmetry in the implied volatility levels across different options contracts with the same expiration date but different strike prices.
Typically, volatility skew is observed in the context of equity options. In a perfectly symmetric world, one would expect all options contracts of the same underlying asset and maturity to have the same implied volatility. However, this is not the case in reality. Volatility skew indicates that the implied volatility levels vary depending on the strike price and can provide valuable insights into market sentiment and potential price movements.
There are two main types of volatility skew: the positive skew and the negative skew. Positive skew, also known as a smile, occurs when the implied volatility increases as the strike price moves further out of the money or in the money. This pattern is often seen in equities during turbulent times when there is increased demand for out-of-the-money options for protection against extreme market movements.
On the other hand, negative skew, also referred to as a smirk, occurs when the implied volatility is higher for at-the-money options compared to out-of-the-money or in-the-money options. This skew is commonly observed in index options where there is higher demand for at-the-money options for portfolio hedging purposes.
Investors and traders use volatility skew analysis to evaluate the relative pricing of options and to assess market expectations regarding future volatility and potential price movements. Understanding volatility skew can help market participants make more informed decisions when trading options and designing trading strategies.
Moreover, volatility skew can impact the pricing of complex option strategies such as vertical spreads, straddles, and strangles. By taking into account the prevailing volatility skew, investors can optimize their risk-reward profiles and enhance their overall portfolio performance.
In conclusion, volatility skew is a vital concept in the world of finance that provides key insights into market dynamics and options pricing. By analyzing volatility skew, investors can gain a deeper understanding of market sentiment and potentially identify trading opportunities that align with their risk tolerance and investment objectives.
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