Vertical Skew or Strike Skew is the most common type of Volatility Skew, it refers to the difference in implied volatility between in-the-money (ITM) options, at-the-money (ATM) options, and out-of-the-money (OTM) options of the same underlying asset and with the same expiration date.
In other words, options prices are vertical skewed if different strike prices trade with a different implied volatility.
The volatility skew, which is affected by sentiment and the supply and demand relationship of particular options in the market, provides information on whether fund managers prefer to write calls or puts.
Volatility skew changes over time as market sentiment changes and will always disappears at expiration.
Notice that the implied volatility of the at-the-money (ATM) options is the recognized ‘reference volatility’.
The 4 main types of Vertical Volatility Skew
The graphical representation of the volatility skew plots the implied volatility of each strike price. When the curve of the graph has a balanced symmetrical U-shape, it is known as a “volatility smile“, and when the curve is weighted to a particular side, it is known as a “volatility smirk“.
1. U-shaped curve or “Volatility Smile”
A U-shaped volatility skew means that the ATM options have the lowest implied volatility and the ITM and OTM strikes trade with a higher volatility.
The shape of this curve resembles a “smile”.
This kind of skew is typical for currency markets because currency traders anticipate often extreme movements with a higher probability than predicted by the models.
“Volatility Smile” is most commonly observed in currency options.
2. Reverse Volatility Skew
In this situation the implied volatility of the lower option strikes (below ATM) is higher than the volatility of the ATM strike and the higher option strikes.
This kind of skew is typical for institution-dominated markets because pension funds and portfolio managers are mostly long the underlying assets, i.e. stocks and bonds. To “hedge” the risk of falling prices they buy OTM puts and/or sell OTM calls. As a result, they drive up the prices and volatility of the OTM puts and drive down the prices and volatility of the OTM Calls.
Reverse skew is most commonly observed in index, stocks and bonds options.
3. Forward Volatility Skew
In this situation the implied volatility of the higher option strikes (above ATM) is higher than the volatility of the ATM strike and the lower option strikes.
This kind of option skew is typical for commodity markets because commodity markets are more volatile when prices increase, e.g. unexpected drought, mine strikes, war, etc. Therefore traders often speculate by buying OTM call options and driving up the prices and volatility of these option strikes.
Forward skew is most commonly observed in commodity options, e.g. oil, metals, agricultural options.
4. Inverse U-shaped curve or “Volatility Frown”
An inverse U-shaped volatility skew means that the ATM options have the highest implied volatility and the ITM and OTM strikes trade with a lower volatility.
The shape of this curve resembles a “frown”.
This type of volatility skew is not very common. It can happen in options with very low volume. The at-the-money options have typically the most trading volume and the lowest spread. If traders wants to take a position, they will buy these at-the-money calls or puts.