Why Options Are Not Priced
Symmetrically: Volatility Skew
Volatility skew explains why two equidistant options from the current price carry different implied volatilities — and how understanding that gap makes you a sharper trader.
What is volatility skew?
In a textbook world, a NIFTY call that is 200 points out of the money and a put that is 200 points out of the money — both with the same expiry — would carry identical implied volatility. In reality they almost never do. The IV of the put is almost always higher. That persistent difference is called volatility skew.
Skew is not a pricing error or an arbitrage opportunity. It is the market's rational reflection of the asymmetric risk in equities: crashes are sharper and faster than rallies, so downside protection (puts) commands a persistent premium. Reading skew tells you how much fear the market is embedding into prices at any given moment.
The skew curve
Plot implied volatility on the y-axis and strike price on the x-axis for a single expiry, and you get the volatility smile or, for equity indices, the volatility smirk. For indices like NIFTY and Bank Nifty the smirk slopes downward from left (low strikes, high IV) to right (high strikes, low IV). The practical meaning: deep OTM puts are expensive relative to theoretical models; OTM calls are relatively cheap.
Why the skew exists: the economics of fear
Three structural forces create and sustain skew in Indian equity index options:
- Insurance demand. Mutual funds, FIIs, and large proprietary desks routinely buy OTM puts to hedge long equity portfolios. This elevated demand drives put premiums — and therefore put IV — higher than a symmetric model predicts.
- Crash-vs-melt-up asymmetry. Historically, equity markets fall faster than they rise. A 5% single-day crash is far more common than a 5% single-day rally. The market prices this into options by making downside scenarios more expensive.
- Seller reluctance on deep OTM puts. Writers of deep OTM puts take on catastrophic risk. To compensate for that tail risk, they demand a higher premium, which keeps put IV elevated.
Measuring skew: a practical number
Traders often quote skew as the IV difference between the 25-delta put and the 25-delta call (the 25-delta risk reversal). A negative risk reversal (put IV > call IV) is the norm for equity indices. When this spread widens, skew is steepening — the market is buying more protection. When it narrows, fear is receding.
On TradePulse's implied volatility dashboard, you can view the IV across strikes for each expiry and track how the smirk shifts day to day, which tells you more about market sentiment than any single number.
A worked NIFTY example
Suppose NIFTY is near 22,500 (illustrative). You check the weekly expiry IV chain:
- 22,500 ATM call IV: 16%
- 22,700 OTM call (200 pts away): 13%
- 22,300 OTM put (200 pts away): 20%
The put 200 points below spot carries 7 percentage points more IV than the equivalent call 200 points above. That gap is the skew. If you buy the 22,300 put and sell the 22,300 call in a risk reversal, you're paying a higher implied volatility for the put — the trade has an embedded cost of skew. Conversely, if you sell the 22,300 put as part of a cash-secured put, you are collecting that premium skew as extra theta.
The lot size for NIFTY is 75 units. At a put premium of, say, ₹80 (hypothetical), one lot generates ₹6,000 (75 × ₹80) in premium collected. The elevated IV means that premium is richer than the call side would offer at the same distance — which is the skew working in the seller's favour.
Skew and strategy selection
Knowing the shape of the skew before entering a trade changes which strikes you choose. Some practical rules:
- Selling OTM puts vs. OTM calls. In a steep skew environment, OTM put selling collects more premium per unit of delta risk than call selling. This makes strategies like short straddles and iron condors asymmetrically skewed toward the put side.
- Spread selection. A bear put spread benefits from steep skew because you sell a put further OTM (where IV is still relatively elevated) and buy a nearer put. The spread is cheaper in net premium terms when skew is flat, but the sold leg is richer when skew is steep.
- Directional call buying. OTM calls are relatively cheap on the skew curve, which is one reason long call strategies appear attractive when IV is broadly low and skew is moderate.
You can pair this skew analysis with IV rank and IV percentile to decide not just which strike but when to enter a position. High IV rank combined with steep skew is a classic setup for put selling.
How skew shifts with market conditions
Skew is not static. Before a Union Budget, RBI policy meeting, or US Fed event, institutional desks load up on puts, steepening the skew sharply. After the event passes without incident, protection is unwound and skew flattens — often rapidly. This dynamic is closely related to the IV crush that follows binary events: not only does the overall IV level collapse, but the skew shape can change significantly too.
Tracking India VIX alongside skew gives the full picture. A high VIX plus steep skew signals broad fear; a moderate VIX with steep skew signals targeted downside hedging. These two inputs together are more informative than either alone.
Common mistakes with skew
- Selling OTM puts purely because they "look expensive" without accounting for the fact that elevated IV partly compensates for real tail risk.
- Comparing put and call IVs at the same strike (e.g., both 22,500) and calling that skew — true skew compares equidistant or equal-delta strikes.
- Ignoring how skew changes the vega exposure in a multi-leg position: your sold put vega and bought call vega move differently when the skew shifts.
- Assuming skew is always steep. In prolonged bull markets with low volatility, skew can flatten considerably, making the historical premium-collection logic less attractive.
Frequently asked questions
What is volatility skew in options?
Volatility skew is the pattern where implied volatility differs across strike prices within the same expiry. In equity index options like NIFTY, OTM puts typically carry higher IV than OTM calls of the same distance, because the market prices in a higher probability of a sharp downside move.
Why do OTM puts have higher IV than OTM calls?
Institutional investors routinely buy OTM puts as portfolio insurance against market crashes. This extra demand pushes up put premiums and therefore their implied volatility. Upside calls see less insurance-driven buying, so their IV stays lower.
How does skew affect options strategies?
Skew makes OTM put selling relatively more rewarding in premium terms, while OTM call buying is cheaper. Spread traders can exploit skew by selling the expensive OTM put and buying an even further OTM put. Skew also guides strike placement in iron condors and strangles.
Does skew change over time?
Yes. Skew steepens when fear rises — before major events or during sell-offs — because put demand spikes. It flattens in calm, trending bull markets when tail-risk concern is low. Watching skew shifts gives an independent read on market sentiment beyond price alone.
Track live IV skew on TradePulse
View the implied volatility curve across all NIFTY strikes and watch how skew shifts in real time — free on TradePulse.