Trading With and Against the Skew: A Framework
Implied volatility is not uniform across strikes and expirations. The options market routinely prices certain regions of the volatility surface higher than others, creating persistent distortions known collectively as the volatility skew. For traders who understand why these distortions exist and how to exploit them, skew trading represents one of the most repeatable, systematic edges available in options markets.
This article lays out the conceptual framework for skew trading, explains the two principal approaches (trading “with” the skew and trading “against” it), and provides concrete implementation guidance for building these positions.
Why the Skew Exists
Standard options pricing models like Black-Scholes assume a symmetric, log-normal distribution of returns. In reality, market participants do not behave symmetrically. Institutional hedgers consistently overpay for downside protection in equity markets, while speculative demand can inflate upside calls. These supply-and-demand imbalances create the skew.
The skew is therefore not a pricing error. It is a direct reflection of where the market perceives asymmetric risk. Out-of-the-money puts on equity indices, for instance, carry higher implied volatility than equidistant calls because investors are willing to pay a premium for tail-risk insurance. This excess demand relative to supply is what makes the skew tradeable.
Key insight: The skew reflects where the options market sees asymmetric risk. “Cheap” and “expensive” are always defined relative to a symmetric model like Black-Scholes. The real world simply isn’t symmetric.
Two Approaches to Skew Trading
1. Trading “With” the Skew
When a trader trades “with” the skew, he is aligning his position with the market’s existing view of where risk is concentrated. In practice, this means purchasing higher-implied-volatility options and selling lower-implied-volatility options.
Why would a rational trader buy options priced at a premium and sell those priced at a discount? Because his market forecast mirrors the consensus reflected in the skew. If the market is assigning elevated implied volatility to a particular strike or expiration, and the trader agrees that the underlying asset is more likely to move in that direction, he is effectively paying for exposure he believes is correctly priced, or even underpriced relative to the actual risk. He gives away theoretical edge because he believes realised outcomes will justify the premium.
The only hard requirement: the option you sell must carry a lower implied volatility than the option you purchase. Beyond that single rule, there is wide latitude in selecting strikes, expirations, and structures.
2. Trading “Against” the Skew
The opposite approach assumes the market is overreacting. If a trader forecasts a symmetric event, one where the underlying is roughly equally likely to move up or down by a given magnitude, he can sell the higher-implied-volatility options and buy the lower-implied-volatility options, capturing the spread between them.
Trading against the skew is fundamentally a reversion-to-the-mean strategy. The trader is implementing a position that benefits from a more normalised trading scenario, where realised moves are closer to symmetrical than the options market currently implies. Because the symmetric Black-Scholes model is the benchmark, the “expensive” options he sells and the “cheap” options he buys give him positive theoretical edge from the outset.
The risk, of course, is that the skew exists for a reason. If the market is right about the asymmetry, the trader’s position will suffer.
Concrete Example: The Calendar Spread as a Skew Trade
Calendar spreads illustrate how skew trading works across the time dimension rather than just the strike dimension.
If a trader believes the market will remain calm in the near term but expects volatility to increase over the coming months, he can implement a long calendar position, selling the shorter-dated option and buying the longer-dated option. This qualifies as trading “with” the skew when the shorter-dated options are priced at materially lower implied volatility than the longer-dated options.
The trader is buying the richer part of the term structure and selling the cheaper part, aligning with the market’s view that future uncertainty exceeds near-term uncertainty. This is a non-directional, pure volatility position. The trader profits not from the underlying moving up or down, but from the relative behaviour of implied volatility across expirations.