Understanding Volatility Skew: A Practical Guide for Options Traders

Volatility skew is a critical concept for anyone trading options, as it reveals how the market perceives different price movements of an underlying asset. By analyzing volatility skew patterns, traders can identify which options are overpriced or underpriced relative to market expectations, and develop more informed trading strategies.

At its core, volatility skew reflects the relationship between implied volatility (IV) and different strike prices. Rather than all options having the same IV regardless of strike price, market participants assign different IV values to call and put options at various strike levels—both at-the-money (ATM), in-the-money (ITM), and out-of-the-money (OTM). When we plot these IV values across different strike prices, we create a curve that reveals the market’s directional bias. If this curve is symmetrical, it’s called a volatility smile; if asymmetrical, it’s called a volatility smirk. The steepness of this curve—what we call skewness—tells us how strongly the market expects price movement in a particular direction.

Types of Volatility Skew Patterns

Understanding the two primary dimensions of volatility skew is essential for effective options trading. Traders can categorize volatility skew based on either the expiration timeline or the direction of the skew itself.

Horizontal and Vertical Dimensions

Horizontal volatility skew compares the IV of the same strike price across different expiration dates. This helps traders understand how market sentiment changes over different time horizons. Vertical volatility skew examines IV differences between various strike prices on the same expiration date—this is where most trading opportunities emerge.

Most active traders prioritize vertical skew over horizontal skew because vertical patterns directly impact the profitability of individual trade structures. By identifying how IV changes across strikes, traders can exploit the relative mispricing of options at different levels, a strategy especially useful in spread trading.

Forward and Reverse Volatility Skew

The direction of volatility skew reveals crucial information about market sentiment and expectations.

Forward skew (also called call skew) occurs when higher strike price options command higher implied volatilities than lower strikes. This pattern indicates bullish market sentiment—traders are willing to pay more for upside protection, reflecting expectations that the underlying asset price will rise. In forward skew scenarios, call options carry higher premiums.

Reverse skew (also called put skew) happens when lower strike prices show higher IV than higher strikes. This pattern suggests bearish or defensive market positioning, as traders are willing to pay elevated premiums for downside protection. Put options become relatively expensive compared to calls. Reverse skew is especially common in markets with limited shorting mechanisms or high shorting costs, since market participants predominantly use options as hedging tools to protect long positions rather than to speculate on upside moves.

Reading the Market Through Volatility Skew

By examining the shape and slope of your volatility skew curve, you can quickly determine whether the market is displaying forward or reverse skew, and measure the degree of skew. This information directly informs your trading decisions—particularly when selecting which strikes to buy and which to sell.

The specific shape of the volatility smile pattern tells you which strike prices represent better value. If the forward skew is pronounced, it suggests strong bullish bias, making higher-strike call options relatively expensive. Conversely, a steep reverse skew indicates significant bearish pressure and expensive put options at lower strikes.

Practical Application in Options Trading

Your volatility skew analysis should guide your choice of trading strategies and strike selection.

In bullish market environments, bull call spreads are the traditional choice—buying an at-the-money or slightly out-of-the-money call while selling a further out-of-the-money call. However, when forward skew is mild or flat, bull put spreads often become more attractive since they cost less to establish. In a bull put spread, you sell a put at a lower strike and buy a put at an even lower strike, collecting premium while limiting risk.

Similarly, reading volatility skew helps you optimize trade spreads like bear call spreads and bear put spreads. By understanding which strikes carry inflated premiums due to skew effects, you can structure spreads that capture that mispricing while maintaining favorable risk-reward ratios.

The key is to use volatility skew not just as a static indicator, but as a dynamic tool that evolves as market conditions and sentiment shift. As you monitor changes in the skew pattern over time, you’ll develop intuition for identifying trading setups where the market has overreacted or mispriced certain options relative to underlying fundamentals.