Module 8 · Lesson 8 of 13 · Options · About 5 minutes
Volatility Skew and Term Structure: The Shape of Implied Volatility
On this page
Before you read: Implied Volatility and the Expected Move Explained
What you will learn
- What volatility skew and the volatility smile describe across strikes.
- What the term structure of implied volatility describes across expirations.
- Why these shapes exist in general terms, and what they cannot predict.
What is skew?
If every strike had the same implied volatility, what would the chart look like?
Implied volatility is backed out of each option’s price, strike by strike. If plotted across strikes, the line is rarely flat. In many stock index options, lower strikes, especially puts below the current price, show higher implied volatility than strikes above. That downward slope is often called put skew. In some markets, both far-out strikes are higher than the middle, forming a smile.
Why does skew exist?
Who pays extra for protection against a sharp drop?
General explanations include demand for downside protection from investors who hold stocks, the tendency of broad indexes to fall faster than they rise, and the way volatility often rises when markets fall. In some commodities, the skew can tilt the other way when sharp upward moves are the larger concern. These are common explanations, not a law.
What is term structure?
Is implied volatility the same for an option expiring next week and one expiring next year?
Term structure compares implied volatility across expirations, often at the money. In calm periods, longer expirations frequently show higher implied volatility than near ones. During stress, the near-term can rise above longer-dated options, so the curve slopes down. Scheduled events, such as an earnings date or a central bank meeting, can lift the implied volatility of the expirations that include them; that event premium is called event volatility.
Skew and term structure diagram
Illustrative diagram constructed for teaching. Not real market data.
The diagram has two panels. The left shows fictional implied volatility across strikes, higher on the left, labeled put skew. The right shows two fictional term structure lines: an upward curve labeled calm and a downward one labeled stressed. All values are made up.
What this does not tell you about skew and term structure
- Where price or volatility will go. The shapes describe current option prices.
- Whether an option is cheap or expensive. That depends on what happens next.
- Real values for any market. Check a live option chain from your broker.
- Nothing here recommends any option trade.
Check yourself
- In a fictional chain, the 90 put shows 28% implied volatility and the 110 call shows 18%. What shape is that? Hint: which strikes are higher?
- Give one general explanation for put skew in stock index options. Hint: who buys protection?
- Why might an expiration that includes an earnings date show higher implied volatility? Hint: event volatility.
Reflect on your own process
- When you note implied volatility in your journal, do you record the strike and expiration it came from?
- Which event dates does your written process check before comparing implied volatility across expirations?
- How would you confirm a skew or term-structure reading on a second platform before recording it?