Skew Trade
A skew trade is an options strategy that profits from changes in the shape of the implied volatility skew — the differential between implied volatility levels across options strikes — rather than from the level of implied volatility or the directional movement of the underlying asset.
The implied volatility skew in equity options markets reflects the systematic tendency for out-of-the-money put options to trade at higher implied volatilities than at-the-money options, which in turn trade at higher implied volatilities than out-of-the-money calls. This asymmetry, sometimes called the volatility smile or smirk, is not predicted by the original Black-Scholes model but arises from investor demand for downside protection, the statistical skewness of equity return distributions, and supply and demand imbalances in the options market.
A skew trade takes a view on whether this skew will steepen or flatten relative to current levels. The most common skew trade is a risk reversal: buying an OTM put while selling an OTM call of the same expiry and similar delta magnitude. The position profits if the skew steepens — put implied volatility rises relative to call implied volatility — typically during market selloffs when demand for downside protection surges. Conversely, selling a risk reversal profits from skew flattening during rallies when the demand differential narrows.
Another common skew trade is the 25-delta risk reversal on the S&P 500, a widely quoted measure of equity skew that compares the implied volatility of 25-delta puts against 25-delta calls for a given expiry. When this spread is historically wide — typically in post-crisis or high-fear environments — skew sellers argue that downside protection is overpriced. When the spread is historically narrow — in complacent bull markets — skew buyers see cheap insurance.
CBOE publishes the CBOE SKEW Index, which measures the implied probability of extreme negative returns in the S&P 500 based on the shape of the index options volatility surface. When the SKEW Index is elevated, out-of-the-money put skew is steep relative to historical norms. Traders use this index as a barometer for entering or exiting skew trades, though the SKEW Index has an imperfect track record as a short-term market timing tool.
Institutional options desks at U.S. investment banks monitor skew actively because it affects the relative pricing of complex structures, particularly collars, put spreads, and risk reversals embedded in corporate hedging programs. A company buying a collar to hedge a large block of stock exposure is implicitly selling the skew differential between the put and call strikes it is trading, and negotiating that pricing in an environment of steep skew versus flat skew can substantially affect the net cost of the hedge.