Volatility Skew & The Volatility Smile Framework
Why out-of-the-money puts trade at implied volatility premiums, post-1987 crash-o-phobia, and commodity call skew setups.
1. What Is Volatility Skew?
Under the classical Black-Scholes-Merton options pricing model, implied volatility is assumed to be constant across all strike prices. In real financial markets, however, options trading at different strike prices with the same expiration date trade at different implied volatilities — a structure known as the Volatility Skew or Volatility Smile.
2. Downside Put Skew & "Crash-O-Phobia"
Prior to the October 1987 stock market crash, index options traded with a relatively flat volatility structure. Since the 1987 crash, equity index options (such as SPX) exhibit persistent downside skew:
3. Commodity Smiles & Risk Reversals
In commodity markets (like Crude Oil or Natural Gas), the skew frequently flips into a call skew (reverse smile) during supply shortages, where upside out-of-the-money calls trade at high volatility premiums due to panic hedging against sudden supply disruptions.