What is the meaning of “skew” as it relates to options trading?
The basic idea behind skew is that options with different strike prices and different expirations tend to trade at different implied volatilities. When implied volatilities for options with the same expiration are plotted, the graph resembles a smile, with at-the-money volatility in the middle and out-of-the-money options forming the gently-rising sides. As options go into the money they gradually approach their intrinsic value, and an option trading at its intrinsic value has an implied volatility of zero, so for our graph we use call prices for strikes above the current underlying stock price and put prices for strikes below the current underlying stock price.
