The Theory vs. Reality
The Black-Scholes model assumes that implied volatility is the same across all strike prices for a given expiration. If a stock's at-the-money IV is 30%, every strike — from deep in-the-money to far out-of-the-money — should also be at 30%.
In reality, this never happens. Plot the IV of each strike on a graph and you'll see a curve, not a flat line. This curve takes two primary shapes: the volatility smile and the volatility skew.
The Volatility Smile
A volatility smile appears when both far OTM puts and far OTM calls have higher IV than at-the-money options. The graph looks like a U-shape or a smile.
Where you see it: Currency options and commodity options frequently display a true smile. Both extreme upside and downside moves are considered more probable than a basic model assumes.
Why it exists: Markets have experienced enough tail events in both directions that traders demand extra premium for deep OTM options on either side.
The Volatility Skew (Put Skew)
Equity options almost always show a skew rather than a smile. OTM puts have significantly higher IV than OTM calls. The graph slopes downward from left to right.
Typical example:
| Strike (Stock at $100) | IV |
The $80 put has 42% IV while the $120 call has only 23%. The put costs proportionally much more than the call at the same distance from the money.
Why Put Skew Exists
Three forces drive put skew in equities:
1. Crash demand. After the 1987 crash, institutional investors learned the hard way that tail risk is real. Portfolio managers routinely buy OTM puts as insurance, driving up their prices and therefore their IV.
2. Leveraged selling pressure. Stocks fall faster than they rise. A 10% crash happens in days; a 10% rally takes weeks. Options markets price this asymmetry by assigning higher IV to downside strikes.
3. Structural supply/demand. Institutions are natural buyers of puts (hedging) and sellers of calls (overwriting). This creates persistent demand for puts and supply of calls, tilting the IV curve.
How to Use Skew in Your Trading
For put sellers: The steep put skew means OTM puts are relatively expensive. When you sell a cash-secured put at the 20-delta strike, you're collecting premium that's inflated by skew. This is one reason why put selling has historically outperformed its "fair value" — you're selling overpriced insurance.
For spread traders: If you're buying a put debit spread, skew works against you. The put you buy (closer to ATM) has lower IV than the put you sell (further OTM). You're buying relatively cheap and selling relatively expensive. This is why put debit spreads often feel like they don't pay enough.
For call buyers: Skew works in your favor. OTM calls have lower IV than ATM options, making them relatively cheap. Buying call debit spreads benefits from this dynamic.
Measuring Skew
The simplest skew measure compares the IV of the 25-delta put to the 25-delta call. A skew of 8% (put IV is 8 points higher) is typical for SPY. Individual stocks with recent bad news or high short interest may show skews of 15-20%.
Steep skew (above normal): Puts are extra expensive relative to calls. Favor selling puts, be cautious buying them.
Flat skew (below normal): Puts aren't as inflated. Could signal complacency — this often precedes sharp moves.
Skew and Earnings
Before earnings, skew often flattens because upside call demand increases (traders speculating on a beat). After a negative earnings surprise, skew steepens dramatically as put buying surges.
Monitoring how skew changes before and after events gives you an edge in structuring spreads. OptionsPilot displays option pricing across multiple strikes, letting you observe how premiums vary and identify when skew creates favorable selling or buying opportunities.
Key Takeaway
Volatility skew isn't a bug in the market — it's a feature that reflects real risk. Understanding skew helps you choose which strikes offer the best value and which strategies benefit from the structural tilt in options pricing.