why would volatility skew 
volatility skew occurs due to the difference in implied volatility iv levels of options with different strike prices but the same expiration date the iv of an option is a measure of how much the market expects the price of the underlying asset to move the primary driver of volatility skew is the collective expectations and behavior of market participants if investors expect a significant price movement in one direction these investors may be willing to pay more for options that would profit from that move this increased demand can drive up the iv of those options creating a skew also investors often perceive downside risk that is the risk of prices falling as greater than upside potential particularly in equity markets this is because stock prices can only go to zero but there s theoretically no limit as to how much they can rise as a result investors are often willing to pay more for put options which increase in value when prices fall than for call options which increase in value when prices rise this can result in higher iv for otm put options creating a volatility skew additionally certain market events such as earnings announcements or economic reports can also create a volatility skew if investors expect these events to cause significant price movements they may be willing to pay more for options that would profit from those movements this can create a temporary volatility skew that disappears after the event indeed events such as major market downturns or financial crises can lead to volatility skews for example the 1987 stock market crash led to a significant volatility skew as investors rushed to buy put options to protect against further declines the shape of the volatility skew can provide valuable information about market expectations and potential future price movements however it s important for traders and investors to remember that these are just expectations and actual future price movements may be different 2implied volatility values are often computed using the black scholes option pricing model or modified versions of it the interpretation of a volatility skewinterpreting a volatility skew involves understanding the implications of the shape and slope of the skew some interpretations of the volatility skew include it should be noted that the volatility skew is based on market expectations which can change over time therefore it s important for investors and traders to continually monitor the skew and adjust their respective strategies accordingly also the skew should be used in conjunction in with other market indicators 34determining abnormal volatilitya volatility skew can be used to identify abnormal volatility in the market a significant change in the volatility skew can indicate abnormal volatility one example entails when the skew becomes more negative that is the iv of otm put options increase relative to call options it could suggest that investors are expecting a significant downward price movement which would likely be accompanied by increased volatility also by comparing the current volatility skew to its historical levels traders and investors can identify if the current market expectations reflected in the skew are abnormal if the skew is significantly different from its historical average it could suggest that the market is expecting abnormal volatility 5furthermore a volatility smile where the iv is higher for both otm and itm options compared to atm options can indicate that the market is expecting large price movements in either direction this suggests abnormal volatility another note is if the implied volatility varies significantly across different strike prices that is the skew is steep it could suggest that the market is experiencing abnormal volatility 6while volatility skew can provide valuable insights into market expectations it should not be used in isolation other factors such as market news economic indicators and even other technical analysis tools should be considered when assessing the likelihood of abnormal volatility a volatility smile means that the iv of options on a particular underlying security or market index increases as the options become further itm or otm with the lowest point generally occurring atm the pattern is often depicted as a v shaped curve a volatility smile has several important implications for options pricing and market expectations they are as follows 7the formation of a volatility smirka volatility smirk occurs when iv for options on an underlying security or index decreases as the options become more deeply itm or otm the pattern is often depicted as a curve that slopes downward resembling a smirk the implications of a volatility smirka volatility smirk has several implications for options pricing market expectations and risk management this include 8the benefits and limitations of analyzing volatilityanalyzing volatility in the financial markets can provide several benefits but as with any form of analysis or technique there are limitations the benefits of analyzing volatilityvolatility is a key measure of risk in financial markets higher volatility typically indicates higher risk as it suggests larger potential price swings this can help investors assess the riskiness of different assets or portfolios also by understanding the volatility of different assets investors can better diversify their portfolios assets with low correlation and different volatility levels can provide diversification benefits indeed volatility is a crucial input in the pricing of derivatives such as options higher volatility generally leads to higher option prices furthermore changes in volatility can provide market insights into market sentiment for example rising volatility may indicate increasing uncertainty or fear among market participants traders and investors alike use volatility to inform their investment strategies they may use strategies such as straddles or strangles in a high volatility environment 9some limitations with analyzing volatility include the calculation of volatility the stability of volatility the normal distribution assumption volatility clustering and the lack of direction in volatility analysis historical volatility calculated from past price changes may not accurately predict future volatility implied volatility derived from option prices can provide a forward looking estimate but is based on market participants expectations which may not always be accurate 1011indeed volatility itself can be volatile it can change rapidly in response to market events making it difficult to predict moreover many models that use volatility assume that price changes follow a normal distribution however in reality financial returns often exhibit skewness and kurtosis meaning that they have asymmetric and fat tailed distributions 12also financial markets often exhibit volatility clustering where periods of low volatility tend to be followed by periods of high volatility and low volatility periods are followed by high volatility this complicates the analysis 13finally volatility measures the magnitude of price changes but it does not provide any information about the direction of the change high volatility could mean large price increases large price decreases or a mixture of both 