Stock Market · Options Theory

Volatility skew & smile

In a perfect Black-Scholes world, IV would be the same for all strikes of the same expiry. In reality, it isn't. This variation in IV across strikes is called volatility skew or smile.

The volatility skew for equity indices

For equity indices like Nifty, OTM puts typically have HIGHER IV than OTM calls, and ATM options sit in the middle.

Plotting IV against strikes produces a downward slope from left to right. Called a skew or smirk.

Why does the skew exist?

Demand and supply. Large institutional investors and fund managers buy OTM puts to protect their portfolios from market crashes. This excess demand drives up IV (and premium) for OTM puts.

Conversely, institutions often sell OTM calls to generate income, suppressing their IV.

> The put skew quantifies how much the market is willing to pay for downside protection relative to upside participation.

Volatility smile

In commodity and some currency options, both OTM calls and OTM puts have higher IV than ATM. Creating a 'smile' shape. This happens because extreme moves in either direction are considered more likely than Black-Scholes assumes.

Practical implications for traders

• Buying OTM puts is expensive due to skew. Consider bull put spreads instead (sell an OTM put, buy a further OTM put) to reduce the skew penalty.
• Selling OTM puts collects IV premium from the skew, but has significant downside risk if markets crash.
• Understanding skew helps price multi-leg strategies accurately.

Put-call skewOTM puts cost more than OTM calls on equity indices. This is normal.

Check the skew on NSE's option chain before entering. The 'wings' of the distribution don't price symmetrically.

Takeaway. Volatility skew: OTM puts have higher IV than OTM calls for equity indices. Driven by demand for downside protection. Skew makes buying puts expensive and selling puts more attractive but risky.