The volatility skew strategy is an advanced options trading approach that seeks to profit from differences in implied volatility across different strikes or expirations of options on the same underlying asset. Volatility skew refers to the uneven distribution of implied volatility, where options at different strike prices or maturities trade at different volatility levels. By understanding and exploiting these differences, traders can uncover opportunities that are not visible through simple price analysis. In this guide, you will learn what volatility skew is, how the volatility skew strategy works, and how to apply it effectively.

What is Volatility Skew?

Volatility skew occurs when implied volatility is not uniform across all options on the same underlying asset:

• Vertical Skew (Strike Skew): Implied volatility varies depending on the strike price. Out-of-the-money (OTM) puts often have higher implied volatility than OTM calls due to demand for downside protection.
• Horizontal Skew (Term Structure Skew): Implied volatility varies across different expirations. Short-dated options may have lower volatility than long-dated ones, or vice versa.

Volatility skew reflects investor sentiment, risk expectations, and supply-demand dynamics in the options market.

For example, if traders fear a market drop, they may aggressively buy puts, raising implied volatility for lower strike options compared to calls.

How the Volatility Skew Strategy Works

The volatility skew strategy aims to exploit these variations in implied volatility by:

• Selling Overpriced Options: Sell options with unusually high implied volatility relative to others.
• Buying Underpriced Options: Buy options with lower implied volatility expected to rise.
• Constructing Spreads: Create trades like vertical spreads, calendar spreads, or ratio spreads that benefit from changes in volatility skew.

Rather than betting purely on direction, traders using this strategy focus on volatility distortions to capture profit.

How to Apply the Volatility Skew Strategy

1. Analyse the Volatility Skew
Use options analytics platforms like TradingView, Thinkorswim, or Bloomberg to view implied volatility curves across strikes and expirations.

2. Identify Opportunities
Look for anomalies where volatility at certain strikes or expirations is significantly higher or lower than the average:

• High Volatility Puts: Consider selling high-volatility puts if downside fear is overpriced.
• Low Volatility Calls: Consider buying low-volatility calls if bullish sentiment is underestimated.

3. Build a Strategic Options Position
Depending on the skew:

• Vertical Spread: Buy and sell options at different strikes to profit from strike skew.
• Calendar Spread: Sell short-term options and buy longer-term ones if term structure skew is steep.
• Ratio Spread: Sell multiple higher-volatility options against fewer lower-volatility options.

4. Manage Risk Diligently
Use defined-risk spreads to limit potential losses. Monitor positions frequently as volatility skew can change rapidly, especially around earnings or news events.

5. Exit Strategically
Take profits as volatility normalises or if your position benefits from directional movement or time decay.

By following these steps, traders can systematically exploit volatility skew to enhance returns.

Benefits of the Volatility Skew Strategy

This strategy offers several key advantages:

• Non-Directional Opportunities: Profit without needing to predict market direction.
• Enhanced Risk-Reward: Volatility distortions can offer attractive entry points with favourable payoffs.
• Diversification: Adds an additional layer of strategy beyond simple long or short trades.
• Exploits Market Inefficiencies: Volatility skew often reflects emotional biases, providing opportunities for rational traders.

Because of these benefits, volatility skew strategies are a staple for professional options traders and hedge funds.

Risks of the Volatility Skew Strategy

Despite its advantages, there are risks to manage:

• Volatility Shifts: Sudden events can change implied volatility across the board, impacting your spread.
• Directional Moves: Large price movements can turn a non-directional trade into a directional loser.
• Liquidity Risks: Skew-based trades may involve less liquid options, leading to wider spreads and slippage.
• Complexity: Analysing and trading volatility skew requires a deeper understanding of options pricing and risk.

Careful analysis, defined-risk positions, and active monitoring are essential for success.

Best Tools for Volatility Skew Strategy

Some essential tools include:

• Options Analytics Platforms: Tools like Thinkorswim, TradingView, or OptionsPlay for visualising volatility skew.
• Implied Volatility Calculators: To track real-time changes in implied volatility curves.
• Economic Calendars: To be aware of events like earnings or central bank announcements that can shift volatility.

Reliable tools ensure that your skew analysis is accurate and actionable.

Conclusion

The volatility skew strategy provides a smart way to profit from inefficiencies in the options market by focusing on differences in implied volatility. By identifying overpriced and underpriced options and constructing strategic spreads, traders can exploit emotional biases and market imbalances. However, success demands a solid grasp of options mechanics, disciplined risk management, and constant vigilance.

If you are ready to master advanced options strategies like volatility skew trading, enrol in our Trading Courses and start developing a professional-level trading edge.