Volatility Skew

Volatility skew (also called the volatility smile or smirk) describes the phenomenon where implied volatility is not constant across all strike prices for options with the same expiration date. In equity markets, out-of-the-money puts typically have higher implied volatility than at-the-money or out-of-the-money calls, creating a "skew" or "smirk" pattern. This reflects higher demand for downside protection (puts) and the market's recognition that stock returns are negatively skewed — large drops are more common than equivalent large gains. The skew became pronounced after the 1987 crash, when markets realized that extreme downside events (tail risks) were more likely than Black-Scholes models predicted. In commodity markets, the skew may be reversed (calls more expensive) if supply disruptions could cause sharp price spikes. Traders analyze skew to assess market sentiment, identify relative value opportunities, and structure trades that exploit the term structure of volatility. Changes in skew often signal shifts in institutional hedging demand and risk perception.