Volatility Skew
Why OTM puts are more expensive than OTM calls
What Is Volatility Skew?
Volatility skew is the phenomenon where the implied volatility of options varies by strike, even though they share the same underlying and the same expiration date. Specifically, skew refers to OTM options frequently being priced at higher implied volatilities than ATM options. For individual stocks, the skew is typically "inverted" or "negative", meaning that OTM puts trade at higher implied volatilities than OTM calls the same distance from the money. This contrasts with the Black-Scholes model, which assumes a flat, constant volatility across all strikes. Skew is an empirical observation that contradicts the theoretical model. It matters because it means the prices in the chain are not the ones a flat-volatility Black-Scholes predicts. The market incorporates something that simplified model does not: that declines are faster and more correlated than advances.
Why Skew Exists: Theoretical Explanations
There are several theories about why volatility skew exists. One is "stochastic volatility": the idea that volatility itself fluctuates over time and the market prices that in. When price falls, volatility tends to rise (a negative correlation), which makes OTM puts more valuable. Another is "tail-risk aversion": investors fear extreme downside moves, especially black swans and market shocks, so they are willing to pay more for OTM puts as protection. After the 1987 crash (when the market fell 20% in a day), institutional investors began buying OTM puts en masse as insurance, pushing their prices up. A third is "supply-demand equilibrium": there are more buyers of puts for hedging than natural sellers, so puts become more expensive. A fourth is "risk-adjusted probability": the market anticipates that the downside of price movement is more likely than normal theory assumes, requiring higher volatility in that tail.
The Shape of Skew: Smile vs Smirk
The skew pattern generally takes one of two shapes. A "volatility smile" is where IV is low at the ATM strike and rises at both the OTM call strikes and the OTM put strikes. That is the characteristic shape of the currency market, where neither direction is perceived as more dangerous than the other. A "volatility smirk" is where IV is relatively normal in the calls but becomes progressively higher as you move toward OTM puts. That is the typical shape for individual equities. Negative skew (more expensive puts) is especially pronounced after events that caused market declines, such as the March 2020 crash. Skew can change significantly over time. When the market is calm, skew can be relatively flat. When there is anxiety, it can become very steep. Traders use changes in skew as a signal of changes in market sentiment.
Trading Implications of Volatility Skew
Volatility skew has important implications for options trading. First, if you buy OTM puts for hedging, you are paying the higher implied volatility inherent in the skew. That is the price of the insurance. Second, if you sell OTM puts, you are collecting the elevated premium but also making an implicit bet that volatility will not rise (which is correlated with price declines). Third, skew affects how credit is distributed in two-sided structures: in an iron condor, the put leg contributes considerably more premium than the call leg at the same distance from price, which lets you push the downside further out while keeping the same total credit. Fourth, traders can bet on "skew breaks" where the volatility pattern shifts suddenly. Fifth, using Black-Scholes with flat volatility and ignoring skew produces significant pricing errors. Professional option sellers always account for skew when pricing and selecting strikes.
Skew and Tail Risk
Volatility skew is, fundamentally, how the market acknowledges tail risk: the possibility of extreme events. Normal-distribution models assume price changes follow a bell curve, with extreme events being very rare. Market reality, however, shows that extreme events (very large price changes) occur far more frequently than the normal distribution predicts. This is known as "fat tails". Investors who recognise that tail risk are willing to pay more for OTM puts as protection against those events. After historic market shocks (1987, 2008, 2020), skew becomes particularly pronounced. Option sellers should be aware that selling deep OTM options with apparently low skew is risky, because they are implicitly underestimating the probability of extreme events. An unanticipated tail event can produce enormous losses. That is why professional option sellers demand sufficient capital and impeccable risk management.