Distinguishing Volatility Smile Effects from Directional Skew

Summary

The document addresses why option implied volatility may show a smile or a directional skew, and whether turbulent markets necessarily make one pattern more likely. Its central distinction is that a smile reflects a premium across the wings associated with tail outcomes, while skew reflects the market’s relative pricing of risk in one direction. A move in one side of the volatility surface may therefore indicate demand for protection against a particular direction, shaped by expectations or existing positions.

The answer also suggests that wing volatility premiums can be lower in volatile markets because of a “cabinet effect” when volatility is very low. This brief explanation challenges the assumption that elevated uncertainty alone implies stronger demand for out-of-the-money calls and in-the-money puts. It offers no data, formal definition of the effect, or detailed account of the GBP/USD example, so the claims should be treated as intuition rather than a general empirical rule.

Key ideas

• A volatility smile and a directional skew describe different features of option pricing.
• Smile premiums relate to pricing across the wings of the volatility surface.
• Skew can reflect demand for protection against a particular direction of market movement.
• The document suggests wing premiums may be lower in volatile markets, but provides no empirical support.

Tags

# Volatility Smile/skew in volatile markets


# Volatility Smile/skew in volatile markets












In a volatile market with uncertainty it's more likely that we see a volatility skew and not so much a smile. Therefore it must hold that, in chaotic markets, out-of-the-money calls and in-the-money puts are in greater demand than in-the-money calls and out-of-the-money puts.(am I correct?)

But how come OTM calls and ITM puts are more in demand in volatile markets?

Eg. the day after Brexit there is a skew for GBPUSD options

## Answer by Nivel Egres (score 2, accepted)

https://quant.stackexchange.com/a/32703

Actually, you are going to find that the vol premium on the wings is lower in volatile markets, purely due to the "cabinet effect" when vol is very low.

I think, however, that you are mixing up smile (aka kurtosis premium) with skew (risk direction premium). When a specific side of the vol surface moves that usually means people are trying to protect against a specific direction move, either due to perception or due to market position

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.