Volatility Smile and Volatility Skew – Part 5: Strike Skew vs. Time Skew

Go Back to Part 4: Volatility Smile and Skew Implications

Strike Skew vs. Time Skew
Actually, there are 2 types of volatility skews: Strike Skew and Time Skew.

1) Strike Skew, or sometimes called Vertical Skew, is obtained by plotting Implied Volatility of an option with the same expiration month across various strike prices.
This is the most common type of Volatility Skew.
The volatility skew that has been discussed so far in the previous posts is Strike Skew.

2) Time Skew, or sometimes called Horizontal Skew, is obtained by plotting Implied Volatility of an option with the same strike price across various expiration months.
This kind of volatility skew might be seen as an indicative of market’s future expectations on a stock.

Generally speaking, it is possible for options with any expiration month to have higher IV levels than options with the other expiration months.
Because this volatility skew is mainly driven by expected price movement surrounding an impending news event that may significantly affect the stock price.
These skews can arise and disappear as the news event approaches and then passes.

Nevertheless, the typical time skew pattern observed is higher IV for options with shorter time to expiration than for longer-time-to-expiration options.
One possible reason is that most speculators are probably more interested in betting on “surprises” that are expected to occur in shorter term than those in longer term.
As such, they would also prefer options with shorter time to expiration, as these options are lower in terms of dollar value (as it carries less time value than longer-time-to-expiration options), and hence can potentially provide higher % returns when the extreme price movement does take place as expected.
This would consequently increase demand for shorter time options, and hence push the options’ price up through higher IV.

To understand more about other aspects of Implied Volatility, go to: Understanding Implied Volatility (IV).

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