Skew, smile & term structure

The three dimensions

An option’s IV depends on:

1. Strike (moneyness): different strikes have different IVs → skew or smile
2. Time to expiry: different expiries have different IVs → term structure
3. Time (calendar): IV changes over trading days → dynamic vol

Combined: the volatility surface — a 3D landscape of IV.

Skew — the vertical dimension

For a given expiry, plot IV against strike. Result:

• Equity indices (Nifty, S&P): downward-sloping. OTM puts have highest IV, OTM calls have lowest. This is the “put skew” or “volatility skew.”
• Individual stocks: often U-shaped (“smile”). Both OTM puts AND OTM calls have elevated IV.
• Commodities: sometimes upward-sloping (crude, ags) — OTM calls higher due to shortage risk.

Why Nifty has put skew

Portfolio insurance demand. Institutional traders continuously buy Nifty puts to hedge equity portfolios. This constant buying pressure lifts put IV relative to call IV.

Crash risk pricing. Real drops are faster than rallies. Markets go up escalator, down elevator. Options price this asymmetry.

Result: Nifty OTM puts are systematically more expensive than equidistant OTM calls.

Term structure — the horizontal dimension

Plot ATM IV against days to expiry. Three patterns:

Contango (normal): short-dated IV < medium-dated IV < long-dated IV

• Suggests calm now, more uncertainty later
• Selling short-dated + buying long-dated (calendar/diagonal) profits from theta

Flat: all expiries same IV

• Uninformative regime, no clear trade signal

Backwardation: short-dated IV > medium > long

• Suggests near-term event or fear
• Warning sign — market expects a big move soon
• Buying short-dated straddles becomes cheap relative to expected move

Smile — the U shape

Some assets (commodities, biotech stocks, single-name event risk) show U-shaped IV:

• OTM calls elevated (upside surprise possible)
• OTM puts elevated (downside crash possible)
• ATM IV lowest

Common on:

• Pharma stocks around results
• Small-caps with M&A speculation
• Commodities with supply/demand shocks

How to use skew

1. Selling premium: pick the fatter side

When selling strangles, sell more OTM on the low-IV side, less OTM on the high-IV side. For Nifty:

• Call: 2% OTM (higher premium per unit of risk in low-IV zone)
• Put: 1.5% OTM (accept smaller cushion — put IV is already inflated)

2. Buying insurance: watch the skew steepness

If put skew steepens dramatically, insurance is getting expensive → hedges may not be cost-effective. Consider portfolio hedging via futures instead.

3. Vertical spreads exploit skew

Bull put spread (sell higher-strike put, buy lower-strike put): benefits from steep put skew. The short put pays richly; the long put is cheaper (deeper OTM = lower IV).

Sample volatility surface (Nifty)

Rough shape at any given moment:

Down-sloping skew, term structure in mild contango — a “normal” Nifty day.

When the surface changes shape

Watch for skew steepening — a sign of institutional put buying (defensive positioning). Often precedes market weakness.

Watch for term structure inversion (backwardation) — always signals near-term uncertainty (event, macro data, geopolitics).

Watch for smile emerging on Nifty — unusual; suggests two-way risk being priced (rare but happens near elections, major RBI meetings).

Advanced: skew as a trading signal

Some quant traders trade skew changes:

• Skew ratio = 25-delta put IV / 25-delta call IV
• Long-run average for Nifty: ~1.20-1.30
• Skew ratio > 1.5 = fear extreme → contrarian bullish signal (fade fear)
• Skew ratio < 1.1 = complacency → contrarian bearish signal

Not for beginners but worth knowing as you grow.