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IV Skew Analysis

Watch here, How to use IV Skew Analysis?

What is IV Skew Analysis?

IV Skew Analysis involves examining the difference in implied volatility (IV) between different strike prices of options. It helps traders identify potential opportunities and gauge market sentiment based on how IV varies across various options contracts.

Understanding Implied Volatility (IV) Skew

Implied Volatility (IV) Skew is a crucial concept in options trading that refers to the uneven distribution of implied volatility across different strike prices of options on the same underlying asset. It plays a significant role in understanding market sentiment and identifying potential trading opportunities.
IV skew arises when the IV of options with lower strike prices (usually put options) differs from those with higher strike prices (usually call options).
Generally, in equity markets, the IV skew tends to be negative, meaning that the IV of out-of-the-money put options is higher than that of out-of-the-money call options. This is because investors often demand more protection against potential downside moves, leading to higher IV for puts.

Traders and investors analyse IV skews for the following reasons:

  • Trading Strategies : IV skew helps identify overpriced or underpriced options, leading to better options trading strategies.
  • Risk Management : Understanding IV skew helps manage risk in options positions by adjusting strategies accordingly.
  • Market Sentiment : Negative IV skew indicates cautious or bearish sentiment among investors, offering insights into the market mood.

Interpretation of IV Skew Analysis

Volatility skew also called IV skew is the imbalance between out-of-the-money (OTM) calls and puts' implied volatility. Implied volatility is a measure of how much an option's price is expected to fluctuate over its lifetime.
IV Skew is a chart plot of IV levels of all strike prices
IV skew shows real-time IV of every strike of both call/put sides for every scrip.
This chart plot forms a shape of “U” as OTM options will have higher IV compared to ATM.

How to forecast IV skew

With the shifting nature of the market, the IV Skew's shape can be broadly divided into four regimes.

  • Flattening IV skew : An IV skew tends to flatten, becoming more of a horizontal curve on the right and the left wing of the "U"-shaped IV skew. This phenomenon typically indicates that the underlying is moderately bullish and trending upward with a slight positive drift.
  • A thickening IV : This happens when the wings of the U shaped IV skew starts looking more like a V. It will happen when both Call and Puts writers are nervous about writing options and want extraordinary compensation to sell options, be it calls or puts.
  • Left steepening of the IV : Left steepening means that the IV of OTM Puts is increasing at a faster pace. This happens when there is a very high demand for OTM Puts for directional trades.
  • Right steepening of IV skew : If the right wing is getting steeper, it might be because something unexpected is expected to happen. Hence, this formation might not be feasible and should be ignored for a trade.

Let's interpret with an Example

In the above Image, you can see Puts Out-of-the-money (OTMs) strikes IV skew risen upside and Calls Out-of-the-money (OTMs) strikes IV skew remains flattened.
As per the above forecast analysis, whenever the IV skew rises from the left side upward then high demand is been seeing in OTM puts.
Left upward steepening of the IV skew refers to a situation where the implied volatility of out-of-the-money (OTM) put options increases at a faster rate compared to OTM call options. This phenomenon indicates a higher demand or increased market expectation for downside protection or bearish positions. As we can see the Calls OTM strike prices were just coming down or been flattened for the day. If the implied volatility (IV) skew chart of out-of-the-money (OTM) call options shows a decrease or flattening in implied volatilities across different strike prices, it implies a decrease in the demand.