Volatility Skew and Smile in Options, Clearly Explained
Open any index options chain and read the implied volatility column. A put 1,000 points below spot will usually show a higher implied volatility than a call 1,000 points above spot, even though both sit the same distance away. That gap is volatility skew.
Volatility skew is the pattern where options on the same underlying and the same expiry trade at different implied volatilities depending on their strike price. A volatility smile is the version of that pattern where both wings sit above the middle, forming a U shape.
This matters because skew is what you actually pay when you buy protection. Below: why one index has many implied volatilities, the shapes and what they signal, a worked example showing the rupee cost of skew, and where reading it goes wrong.
Why does one index have many implied volatilities?
Implied volatility is not a measured quantity. It is the number you get when you take the market price of an option and run a pricing model backwards to find the volatility that justifies that price.
Standard models assume returns are normally distributed and volatility is one constant for the whole underlying. Real markets disagree. Indices fall faster than they rise, big moves happen more often than a normal distribution predicts, and demand for downside protection is structurally higher.
So the market prices far out of the money puts above what the model says they are worth. Feed that richer price back into the model and it returns a higher implied volatility. Skew is the model admitting its own assumption is wrong.
If implied volatility is new ground, the walkthrough on what implied volatility actually measures comes first.
Smile, skew and smirk: reading the shapes
| Shape | What the curve looks like | Commonly seen in | What it signals |
|---|---|---|---|
| Volatility smile | Both wings higher than the middle, roughly symmetric | Currency pairs, some commodities | Market expects a big move, direction unclear |
| Reverse skew (put skew) | Low strikes highest, sloping down toward high strikes | Equity indices | Crash fear and hedging demand on the downside |
| Forward skew (call skew) | High strikes highest, sloping up | Individual stocks with event or takeover upside | Upside move seen as the bigger risk |
| Smirk | One wing lifted, the other flat | Most single stocks | Lopsided risk, usually downside |
| Flat curve | Similar implied volatility across strikes | Very quiet, liquid markets | No strong directional fear priced in |
Indian index options normally show a reverse skew. Buyers of protection are willing to overpay, and sellers of far out of the money puts demand compensation for a risk that shows up all at once.
A worked example: the rupee cost of skew
Take an index at 25,000 with about 30 days to expiry. Assume a lot size of 75, and check the current lot size on the exchange website since it is revised periodically. These premiums are illustrative.
- 24,000 put, 1,000 points out of the money: implied volatility 17%, premium 95 points
- 25,000 at the money options: implied volatility 13%
- 26,000 call, 1,000 points out of the money: implied volatility 11%, premium 30 points
Skew between the wings is 17% minus 11%, which is 6 volatility points.
Now convert that to money. One lot of the put costs 95 multiplied by 75, which is Rs 7,125. One lot of the call costs 30 multiplied by 75, which is Rs 2,250. Equal distance from spot, and the put costs more than three times as much.
How much of that is skew rather than distance? If the put were priced at the call’s 11% implied volatility, its premium would be roughly 45 points instead of 95. That is 50 points of skew premium, or 50 multiplied by 75, which is Rs 3,750 per lot.
Read that again. Over half the cost of that hedge is the skew, not the strike distance. Any hedging plan that ignores it will underestimate its own bill.
What makes skew steepen?
Skew is not static. It steepens and flattens as positioning changes.
It steepens when the index drifts up quietly and investors buy cheap tail protection, when a known event sits ahead, or when a sharp fall has just happened and hedging demand arrives late. It flattens once panic fades and buyers stop paying up.
One useful habit: watch skew alongside the volatility index, not instead of it. A rising index level says the average expectation of movement is up. A steepening skew says the fear is concentrated on one side. The explainer on reading market volatility and the VIX covers that first measure.
How do traders use skew?
- Choosing structures. Rich put skew makes a single put expensive, so hedgers often prefer a put spread that sells some skew back.
- Financing a hedge. A collar sells a call against a purchased put, though in a put skewed market the call fetches less.
- Picking the leg to sell. Credit strategies sit better on the side where implied volatility is richest, which for indices is the put side.
- Judging spread value. Two strikes with a 5 point volatility gap price very differently from two with a 1 point gap at the same width.
- Reading positioning. Skew that steepens without a price move suggests hedging demand price alone would not show.
Where skew misleads you
Skew is a price, not a forecast. Steep put skew does not mean the market will fall, it means downside insurance is expensive. Traders who read the shape as a signal end up selling protection because it is dear, and that is how one bad week becomes a large loss.
Thin strikes are the second trap. Deep out of the money options often carry very wide bid ask spreads, so the implied volatility your platform shows may come from a stale mid price. Check open interest and the spread first, which the guide to reading an options chain properly walks through.
Third, skew shifts across expiries. The near month curve is usually steeper than the far month at the same strikes, so comparing a weekly wing to a monthly wing tells you about the calendar, not the skew.
A plain risk note. Selling in the steep part of the curve looks statistically attractive and is where the largest retail losses occur, because the payoff is small and frequent while the loss is large and rare.
Frequently Asked Questions
Is a high implied volatility on a put a sign the stock will fall?
No. It tells you that put is expensive relative to a flat volatility assumption, usually because hedgers are bidding for it. Skew reflects demand for protection and the market’s memory of sudden falls. Plenty of steeply skewed markets go on to rise, and plenty of flat ones fall.
Why do equity indices show put skew instead of a symmetric smile?
Because equity declines tend to be faster and more correlated than advances, and because large holders are natural buyers of downside protection rather than upside. Currencies show a fuller smile since a big move either way is plausible. The shape follows who needs insurance and how the underlying actually moves.
Does skew affect the option Greeks?
Yes, indirectly. Greeks are computed at a given implied volatility, so a strike sitting on a steeper part of the curve carries different vega and a different effective delta from what a flat volatility model suggests. If you hedge a skewed book using single volatility Greeks, your hedge drifts. The Greeks explainer covers the base definitions.
How do I measure skew as a single number?
The common shortcut is subtracting the implied volatility of a fixed delta call from that of the matching delta put, for example 25 delta put minus 25 delta call, on the same expiry. Using fixed deltas rather than fixed strikes keeps the measure comparable as the index moves.
Is skew the same on Bank Nifty and Nifty?
The shape is usually similar since both are equity indices, but steepness differs. A more concentrated, more volatile index tends to carry a steeper curve and wider wings. Compare both on the same expiry and same delta before assuming a strategy transfers.
Can I trade skew directly?
Only through combinations, since you cannot buy volatility points. A risk reversal, long one wing and short the other, expresses a view on the gap between them. It carries directional risk and margin requirements, so it suits experienced traders rather than a first strategy.
Key Takeaways
- Skew means options on the same underlying and expiry trade at different implied volatilities by strike.
- A smile lifts both wings; equity indices normally show a reverse skew with puts richest.
- Skew exists because pricing models assume constant volatility and normal returns, and markets do neither.
- In the example, over half the cost of a 1,000 point out of the money put came from skew, not distance.
- Steep put skew prices expensive insurance, it does not forecast a fall.
- Measure skew using fixed delta strikes on one expiry, and check spreads and open interest before trusting a far wing.
