Volatility Skew & Term Structure
If you were to look at the original Black-Scholes options pricing formula from 1973, it assumed that Implied Volatility (IV) was a constant. It theorized that a 10% out-of-the-money (OTM) call option and a 10% out-of-the-money put option on the same stock, expiring on the same day, would have the exact same Implied Volatility. However, the spectacular stock market crash of October 1987 shattered this academic theory. When the S&P 500 plummeted over 20% in a single day, institutional investors realized that downside risk in equities is inherently more violent and destructive than upside risk. Consequently, they began demanding heavily inflated premiums to sell protective put options. This permanent shift in market mechanics birthed what we now call "Volatility Skew."
Volatility Skew is the graphical representation of how Implied Volatility differs across various strike prices for the same underlying asset and expiration date. When plotted on a chart, this skew typically forms a "Volatility Smile" or a "Volatility Smirk." In the equity markets (like the S&P 500 or the NIFTY 50), this almost always manifests as a "reverse skew" or "put skew," where OTM puts trade at significantly higher IVs than equidistant OTM calls. The market is effectively saying: "We are far more terrified of a sudden 10% crash than we are excited by a sudden 10% rally." Understanding how to read this skew allows professional traders to gauge the market's true directional fear and to construct trades that exploit these structural pricing imbalances.
Equally important is the "Term Structure" of volatility, which examines how Implied Volatility changes across different expiration dates (time). Just as a yield curve plots interest rates over time, the volatility term structure plots IV over time. Typically, in a calm market, the term structure is in "contango"—meaning short-term options have lower IV than long-term options, because there is more time for unknown, random events to occur in the distant future. However, during a market panic or an impending binary event (like an election or earnings report), short-term fear explodes, pushing short-term IV higher than long-term IV. This inversion is known as "backwardation." Mastering the interplay between strike-skew (vertical) and time-skew (horizontal) elevates a trader from a novice directional guesser to an advanced volatility arbitrageur.
The Anatomy of Volatility Skew
In broad equity indices like the S&P 500 or the NIFTY 50, the volatility skew is deeply rooted in the hedging habits of massive institutional funds. Pension funds, mutual funds, and endowments are inherently "long stock." To protect these multi-billion dollar portfolios from catastrophic crashes, they systematically buy OTM put options. They finance these puts by selling OTM call options—a strategy known as a "collar." This relentless, structural demand for OTM puts, combined with the continuous supply of OTM calls, forces put IVs permanently higher than call IVs. If you map this out, the curve resembles a smirk leaning heavily to the downside.
However, not all assets exhibit a downside smirk. Commodities and certain hyper-growth equities often display a "forward skew" or "call skew." Take crude oil or agricultural commodities, for example. The fear in these markets is a supply shock leading to an explosive upside price spike, not a sudden drop to zero. Therefore, OTM calls on crude oil futures frequently command a higher IV than equidistant OTM puts. Similarly, during the massive retail-driven short squeezes of 2021 (e.g., GameStop), the sheer volume of speculative call buying flipped the traditional equity skew on its head, causing OTM calls to trade at massive IV premiums compared to puts. A trader observing this call skew instantly knows the market is heavily biased toward extreme upside tail risk.
Traders can exploit Volatility Skew by constructing spreads that capitalize on the pricing disparity. For example, if NIFTY OTM puts are severely overpriced due to panic hedging, a trader might employ a "Put Ratio Spread" (buying one put and selling two further OTM puts). By selling the highly inflated farther OTM puts, the trader can often construct a downside protective trade for a net credit. The skew essentially finances the trade. Conversely, if call skew is exaggerated, a trader might look into "Call Ratio Spreads" or "Covered Calls" to harvest the bloated call premiums.
Volatility Term Structure: Contango vs. Backwardation
If Volatility Skew is the vertical analysis of IV across strikes, Term Structure is the horizontal analysis across time. A normal, healthy market environment exhibits a term structure in "contango." In contango, the IV for options expiring next week is lower than the IV for options expiring next month, which is lower than the IV for options expiring next year. This makes logical sense: the longer the time horizon, the greater the statistical probability of an unforeseen macroeconomic shock, a pandemic, or a war. Therefore, sellers of long-term options demand higher premiums to take on that extended time risk.
However, when a sudden crisis hits—like the COVID-19 crash of March 2020 or a sudden banking collapse—the market needs immediate protection. The demand for short-term puts skyrockets, driving short-term IV to astronomical levels (often 80% or 100%+). Meanwhile, long-term IV might only rise modestly (perhaps to 30% or 40%), as the market assumes the crisis will eventually be resolved. This causes the term structure curve to invert, a state known as "backwardation." In the VIX futures market, backwardation is a classic hallmark of peak market panic. Contrarian institutional traders often use a deeply backwardated term structure as a signal that fear is overextended, marking an opportune time to slowly accumulate equity positions or sell short-term premium.
Term structure also plays a critical role around scheduled binary events like earnings reports. If Reliance Industries is reporting earnings in two weeks, the IV for the options expiring immediately after the earnings date will spike aggressively. However, the options expiring a month later will not see the same IV inflation. This creates a localized "hump" in the term structure. Advanced traders use Calendar Spreads (selling the high-IV near-term option and buying the lower-IV long-term option) to isolate and profit from this specific time-based volatility mispricing.
Frequently Asked Questions
Common queries and clarifications
Volatility Skew refers to the difference in Implied Volatility between out-of-the-money, at-the-money, and in-the-money options of the same underlying asset and expiration date.
Written By
Rohit Singh
Mr. Chartist
With 14+ years of experience in Indian financial markets, Rohit Singh (Mr. Chartist) is a SEBI Registered Research Analyst, Amazon #1 bestselling author, and the founder of Investology — a premium trading ecosystem trusted by a 1.5 Lakh+ strong community across India.