Understanding IV Skew

If you trade options, you may have heard the term IV skew. If you know what it is, great. If not, this little blog may shed some light on the subject. If you know what to look for, it can improve your profit potential by putting the odds even more on your side.

An IV skew is when there is a difference in implied volatility (IV) levels for different expirations. For instance, one expiration has an implied volatility of 23% and another has an implied volatility of 28%. Keeping it simple, implied volatility is how options are priced. When IV is higher than normal, option prices are higher than normal and vice versa. Many option traders use the average IV levels over the course of a year to gauge whether IV is currently high or low. Others compare it with historical volatility (HV), which is the volatility of the underlying. IF IV is higher than HV, options may be overpriced and vice versa.

Over the past several months, option traders have seen plenty of IV skews. When selling options you want IV to be high, and when buying them you want it to be low. In other words, sell high and buy low. A longtime spread (like a calendar or diagonal) is when an option trader sells a shorter expiration and buys a longer expiration. A preferred IV skew is for the IV of the short option to be higher than the long option as in the example below.

This gives the option trader an additional slight edge because he or she is selling a higher priced option versus buying a “cheaper” one. The debit is smaller, and the potential profits are bigger.

Option traders should be careful when they see a smaller IV on the short option and a larger IV on the long option as in the example below.

First of all, there is no edge. Second of all, this could be a sign that a volatility event like earnings may take place ahead of the long expiration. In the example above, before February expiration.

This is a topic that can be discussed and debated for a long time. I hope this blog can offer some guidance on what to look for and what not to look for when considering buying a time spread to give you an “extra” edge.

John Kmiecik, Market Taker Mentoring

Trader Education