Options traders quickly discover that not all strikes trade at identical implied volatility levels. Across the same expiration cycle on the same underlying asset, an at-the-money call may carry 18% implied volatility while an out-of-the-money put trades at 24%. This divergence—known as volatility skew—creates pricing inconsistencies that savvy traders exploit, and understanding its structure and causes is essential for anyone trading options systematically.
What Is Volatility Skew?
Volatility skew describes the pattern whereby options at different strike prices on the same underlying and expiration date trade at different implied volatility levels. In theory, if the underlying asset has one true realized volatility on a given day, all options should reflect that same volatility. In practice, the options market prices options at each strike with its own implied volatility, creating a visible tilt or curve across the strike landscape.
This phenomenon has persisted since the 1987 stock market crash and remains a permanent structural feature of major options markets. It exists because there is no pure arbitrage mechanism to eliminate it. While calls and puts at the same strike must trade at equal implied volatility (otherwise conversion or reversal arbitrage would instantly correct any divergence), there is no true arbitrage relationship that links the implied volatility of a 50-strike call to a 55-strike call. Traders can exploit different strikes with different volatilities without triggering arbitrage losses, so the skew persists.
The Three Primary Skew Shapes
Volatility skews take on predictable geometric patterns depending on the market and its participants. Recognizing which pattern you're facing is crucial for deciding how to position yourself.
The "U" Shaped or Smile Skew
The most symmetric pattern appears when volatility rises as you move away from the at-the-money strike in either direction. Imagine plotting implied volatility on the y-axis and strikes on the x-axis; if you connected the points, you'd draw a shallow U-shape. The at-the-money strike sits at the bottom with the lowest volatility (say 16%), while both the in-the-money and out-of-the-money strikes trade at progressively higher volatilities as they move further from the money.
This pattern is common in currency options and reflects the mechanics of vega sensitivity. Far out-of-the-money options have very low vega—meaning their price barely moves when volatility changes by 1%. For a market participant to own deep out-of-the-money options, they demand a higher volatility premium to compensate for the risk of holding illiquid, lottery-like trades. Meanwhile, professional market-makers who sell these deep options require higher volatility compensation because the position is less frequently traded and carries execution risk. The U-shape emerges naturally from these pricing dynamics.
The "Reverse" or "Negative" Skew (Puts Heavier)
In index options, particularly on major equity indices like the S&P 500, a distinctive pattern has dominated since the 1987 crash: out-of-the-money puts trade at much higher implied volatility than out-of-the-money calls, while at-the-money options sit in the middle. If you plot this, the curve slopes downward from left to right—highest volatility on the puts side, lowest on the calls side.
Consider this realistic example on NIFTY 50: suppose the index trades at 20,000 and front-month options carry an average implied volatility of 18%. Under a reverse skew, the 19,500 puts (out-of-the-money) might trade at 24% implied volatility, the 20,000 at-the-money options at 18%, and the 20,500 calls (out-of-the-money) at only 14%. This creates a visible downward slope as you move from lower strikes to higher ones.
This pattern exists because institutional portfolio managers—pension funds, mutual funds, index holders—are naturally long the underlying market. Their real fear is a sudden, sharp decline. To hedge that tail risk, they buy puts and sell calls, creating sustained excess demand for puts and excess supply of calls. Margin requirements for selling naked puts have also risen over the decades, reducing the supply of protection available at reasonable prices. The result: puts are expensive, calls are cheap, and the skew persists even through bull markets.
The "Upside Skew" (Calls Heavier)
In commodity markets—grains, metals, soft commodities—the opposite pattern often emerges: out-of-the-money calls trade at higher volatility than out-of-the-money puts, while at-the-money sits lower. This upside skew reflects the psychology and hedging behavior of commercial traders and speculators in these markets.
Many commodity producers face price floors set by government support, subsidies, or futures contracts. The downside is somewhat protected. But if a drought hits wheat or an unexpected supply shock hits oil, prices can soar with almost no ceiling. Traders willingly pay elevated premiums for out-of-the-money calls—the lottery ticket for unlimited upside. Meanwhile, commercial hedgers (farmers, oil producers) are less interested in buying puts because they have natural downside protection from contracts or government programs. The call side becomes expensive, the put side remains cheap, and the skew tilts upward.
How Vega Intensity Shapes Skew
One key driver of skew patterns is the behavior of vega—the sensitivity of option price to changes in implied volatility. At-the-money options have the highest vega; far out-of-the-money and deep in-the-money options have very low vega.
This creates a pricing trap for inexperienced traders. A deep out-of-the-money option might have a low vega of only 0.5, meaning a 1% move in volatility changes its price by just ₹5 (if trading in rupees). In absolute dollar terms, the option looks cheap—perhaps ₹10 premium. But on a volatility-adjusted basis, you're paying an inflated price for that premium because so little of it is sensitive to future volatility swings. Meanwhile, an at-the-money option with a vega of 8.5 might trade at ₹85 and offer much more sensitivity to realized volatility over the life of the contract. Novice traders often buy deep out-of-the-money options because they look cheap in rupees, not realizing they're buying inflated volatility.
Why Skew Matters for Trading
Volatility skew creates two immediate trading opportunities: relative-value trades and hedge-timing insights.
In a relative-value trade, you identify one strike that appears overpriced on a volatility basis (high implied volatility) and another that appears underpriced (low implied volatility), then structure a position to profit from the gap narrowing. For example, if BANKNIFTY 47,000 puts trade at 22% implied while 47,000 calls trade at 16% implied, you might buy calls (low volatility) and sell puts (high volatility) simultaneously, betting that the gap will compress as the market reprices.
For hedging, skew tells you about market sentiment and fear. When reverse skew (puts expensive) is extreme—say puts trading 8% higher in volatility than calls—it signals that portfolio managers are paying up hard for downside protection. This is often a signal that sentiment has shifted bearish or tail-risk anxiety is elevated. Conversely, when upside skew (calls expensive) widens in a commodity market, it can signal that supply concerns or weather risks are driving speculative demand for upside participation.
Skew Behavior in Rising Volatility Regimes
When overall market volatility increases—during selloffs, earnings announcements, or geopolitical shocks—skew patterns tend to exaggerate. In equity index options, reverse skew becomes more extreme: puts become disproportionately expensive as hedgers frantically buy protection. In commodity options, upside skew can widen as traders bid aggressively for upside exposure in uncertain markets.
Conversely, in low-volatility, quiet markets, skew often flattens. When traders feel safe, they're less willing to pay premium for tail hedges, and the volatility curve across strikes becomes more uniform.
Front-month options (closest to expiration) often exhibit tighter, more volatile skew patterns than back-month contracts. As expiration approaches, liquidity concentrates in the front month, and any supply/demand imbalance amplifies the skew. Once you roll into the next month, you may find a materially different volatility curve.
Practical Reconnaissance: Building Your Skew Map
Before placing any volatility trade, build a mental or written map of the skew. Pull the implied volatility quote for three to five strikes across the expiration you're interested in—both calls and puts. Plot them or note the pattern.
For NIFTY options, if spot sits at 20,500:
- Note the 20,000 calls and puts IV
- Note the 20,500 (ATM) calls and puts IV
- Note the 21,000 calls and puts IV
If the puts widen relative to calls as you go out-of-the-money, you have reverse skew. If calls widen, you have upside skew. If the curve is symmetric, the market is pricing a balanced distribution.
Once you see the pattern, ask yourself: Is this skew consistent with recent price action and market sentiment, or does it look distorted? For example, if NIFTY just rallied hard and upside-skew calls are pricing huge tail upside, but earnings are quiet and the macro picture is stable, the calls may be overpriced. Conversely, if puts are priced cheaper than usual despite elevated market uncertainty, they may offer value.
Building Positions Around Skew
The simplest skew trade is a ratio spread or calendar bias: buy the relatively cheap volatility, sell the relatively expensive volatility. If puts are expensive and calls are cheap on the same strike, buy calls and sell puts (a synthetic long, financially equivalent to a short put spread). If the skew narrows, you profit. If it widens, you lose; size accordingly.
Another approach is strike selection for directional trades. If you're bullish but reverse skew is extreme (puts very expensive), avoid selling puts at your target strike—you're getting paid inflated volatility that won't last. Instead, consider buying calls at a lower volatility (higher strikes), accepting lower theta decay to avoid fighting the skew. Or wait for skew to compress before initiating your hedge sale.
Most important: treat skew as a market signal, not a trading rule. Just because puts are expensive doesn't automatically mean sell them; it means ask why they're expensive and whether that reason is still valid. In 2020, when COVID fears spiked, put skew became extreme—and stayed extreme for weeks as new fears emerged daily. Traders who mechanically sold the "overpriced" skew without accounting for the genuine tail risk got hurt.
Key takeaways
What is volatility skew? Options at different strikes trade with different implied volatilities, creating a predictable curve or tilt across the strike ladder—a permanent feature of major markets with no pure arbitrage fix.
What are the main skew patterns? Equity indices typically show reverse skew (puts expensive, calls cheap), currencies often show a U-shaped smile (both tails expensive), and commodities frequently show upside skew (calls expensive, puts cheap).
Why does skew exist? Institutional hedging (portfolio managers buying puts), commercial supply/demand imbalances (farmers/producers), vega sensitivity, and illiquidity in far out-of-the-money strikes all drive persistent skew.
How does vega affect skew perception? Far out-of-the-money options have low vega, so their high implied volatility translates to small absolute price moves—they look cheap in rupees but are expensive per unit of volatility sensitivity.
How does skew change with market conditions? Reverse skew exaggerates during selloffs and fear spikes; upside skew widens during supply shocks or bullish speculation; skew flattens in calm, low-volatility regimes.
How do I trade skew? Identify which strikes are relatively overpriced and underpriced on a volatility basis, then buy low-vol strikes and sell high-vol strikes, or adjust your directional strike selection to avoid fighting the skew.
Is skew always tradeable? No. Extreme skew often reflects real risks or hedging demand. Trade it when you believe skew has overshot fair value, not just because it exists.
How often should I check skew? Monitor it daily, especially near expiration, earnings, or macroeconomic events. Skew can shift rapidly and signal sentiment change before price does.
Further reading
Options as a Strategic Investment by Lawrence G. McMillan; The New Option Secret: Volatility The Weapon of the Professional Trader by an anonymous volatility specialist.