Volatility Skew

Volatility skew describes the pattern of implied volatility across different strike prices for the same expiration date. In most equity markets, the skew follows a predictable pattern: out-of-the-money (OTM) puts have higher implied volatility than at-the-money (ATM) options, which in turn have higher IV than OTM calls. This creates a "smile" or "smirk" shape when IV is plotted against strike price.

This pattern exists primarily because of demand dynamics. Institutional investors and portfolio managers routinely buy protective puts to hedge their stock portfolios, driving up the price (and therefore IV) of OTM puts. Meanwhile, covered call sellers create supply on the call side, pushing call IV lower. The result is a structural premium for downside protection that persists across market conditions, though its magnitude varies with sentiment and fear levels.

Skew provides valuable information about market positioning and expectations. A steeper-than-normal skew suggests elevated fear and demand for downside protection. A flatter skew suggests relative complacency. When call IV approaches or exceeds put IV (a "reverse skew"), it often signals aggressive speculation on the upside. Options Pilot's Value pillar monitors skew as part of its pricing analysis, helping identify when the skew is unusual and what it implies for strategy selection.