Chapter 39: Volatility Trading Techniques 
VOLATILITY SKEWING 
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After the stock market crashed in 1987, index options experienced what has since 
proven to be a permanent distortion: Out-of-the-money puts have remained more 
expensive than out-of-the-money calls. Furthermore, out-of-the-money puts are 
more expensive than at-the-money puts; out-of-the-money calls are cheaper than at­
the-money calls. This distorted effect is due to several factors, but it is so deep-seat­
ed that it has remained through all kinds of up and down markets since then. Other 
markets, particularly futures markets, have also experienced a long-lasting distortion 
between the implied volatilities at various strikes. 
The proper name given to this phenomenon is volatility skewing: the long-last­
ing effect whereby options at different striking prices trade with differing implied 
volatilities. It should be noted that the calls and puts at the same strike must trade 
for the same implied volatility; otherwise, conversion or reversal arbitrage would 
eliminate the difference. However, there is no true arbitrage between different strik­
ing prices. Hence, arbitrage cannot eliminate volatility skewing. 
Example: Volatility skewing exists in OEX index options. Assume the average volatil­
ity of OEX and its options is 16%. With volatility skewing present, the implied volatil­
ities at the various striking prices might look like this: 
OEX: 580 
Implied Volatility 
Strike of Both Puts and Calls 
550 22% 
560 19% 
570 17% 
580 16% 
590 15% 
600 14% 
610 13% 
In this form of volatility skewing, the out-of-the-money puts are the most 
expensive options; the out-of-the-money calls are the cheapest. This pattern of 
implied volatilities is called a reverse volatility skew or, alternatively, a negative 
volatility skew.