Volatility skew is composed of different implied volatilities (IV) corresponding to different strike prices (ATM, ITM and OTM options) of the underlying asset.

We connect the IV values ​​of different strike prices to form a curve. A symmetrical curve on the left and right sides is called a volatility smile, and an asymmetrical curve is called a volatility smirk. The skewness refers to the slope of these IV values.
 

Horizontal and Vertical Skew

There are two specific types of volatility skew — horizontal and vertical, based on the option expiration date. 

Horizontal skew: Horizontal skew refers to the volatility skew of the same strike price on different expiration dates.

Vertical skew: Vertical skew refers to the volatility skew between different strike prices on the same expiration date.

Generally, traders focus more on vertical skew than on horizontal skew.

Forward and Reverse Skew

Volatility skew can be divided into two types: Forward skew and reverse skew, based on the direction of the volatility skew.

Forward skew: Forward skews occur when higher strike price options have higher IVs than lower strikes.

 

Reverse skew: Reverse skews occur when the IV is higher on lower options strike prices. 

 

We can see from the different volatility smile patterns that the market predicts the probability that the underlying asset will either rise or fall in the future.

The greater the slope of the forward skew generally, the more bullish the market is on the price of the underlying asset for a period of time in the future. In this case, the market places a higher value on the Call option. Conversely, the greater the slope of the reverse skew, the more the market believes the underlying asset price will fall in the future and the higher the valuation of the Put option.

However, in markets where there’s a lack of a “shorting” mechanism, or where the cost of shorting is high, a reverse skew is more common. This is because a large number of options are used primarily to hedge the risk of the underlying asset.

How to Use Volatility Skew

Based on the IV chart you’re looking at, it’s easy to find out if it’s a forward skew or reverse skew, and how much it’s skewed.

Depending on the skewness of the volatility smile pattern, you can determine which strike price options to buy and which strike price options to sell, especially when you consider trade spreads, such as bull-bear spreads.

In a bull market, we usually prefer to trade bull call spreads. However, if the extent of the forward skew is relatively small, perhaps we would consider trading bull put spreads which would cost less.