'Volatility skew' is one of those topics that many traders ignore. It's not something that was understood in the early days (1973 +), when options began trading on an exchange.
A volatility smile is defined as 'a long-observed pattern in which ATM options tend to have lower IV (implied volatility) than in- or out-of-the-money options. The pattern displays different characteristics for different markets and results from the probability of extreme moves'
image courtesy of investorglossary.com
In other words, black swan events occur more often than predicted by mathematical models, and far OTM options trade with a higher implied volatility than ATM options.
In today's world, this volatility smile is so skewed to the downside that the IV of OTM puts is significantly higher than that of ATM options, which in turn have higher IV than OTM calls. This is considered as rational in light of the 'frequent' market crashes. Frequent is defined as far more often than any mathematical model would have predicted.
Kurtosis is the mathematical term used to recognize that not all tails of the curve are created eual and that market crashes are far more common than market surges. Thus, PUT IV exceeds call IV.
The early texts could not mention 'volatility skew' and many of us 'grew up' in the options business with no understanding of the importance of volatility skew. I now shudder to recall that one of my favorite strategies (late 70s and early 80s) was to own ratio spreads in which I would buy one put with a higher delta and sell 2 or 3 times as many puts with a lower delta. I thought I was capturing theoretical edge by selling puts with a higher implied volatility. Today, if anyone were to use that ratio strategy, it would not be to capture edge. It would be more of a bet on where the market is headed next.
Volatility skew is easy to notice. All one has to do is look at IV data for any option chain. Nevertheless, the concept has often proven difficult to explain. Saving me the trouble of attempting to do just that, Tyler Craig at Tyler's Trading recently described volatility skew in a nutshell. Thanks Tyler.
When teaching traders who have not yet discovered the importance of volatility skew, the skew can be used to explain why one specific strategy is more profitable under certain market condition that others. This is an important topic for future discussion.
Mark Sebastian at Optionpit.com suggests one good method for following the volatility skew for a specific underlying asset. It takes a bit of work, but owning a good picture of skew, as it changes over time, is probably worth the small amount of time that it takes to track the data.
Sebastian also makes the important point that it's not a good idea to constantly trade the same strategy, using the same underlying, month after month (Guilty. I'm a RUT iron condor trader.) Instead volatility skew, among other factors, should be considered. Iron condors work well when skew is steep and less well when skew is flatter.
Obviously this discussion is incomplete, but just knowing that volatility skew exists and that it can help a trader get better results, makes it a topic that we should all want to understand.
Lessons of a Lifetime: My 33 Years as an Option Trader