Skip to content

Summary

The constant-volatility assumption of Black-Scholes is contradicted by every real options market: implied volatility varies systematically across strikes (the skew or smile) and across expirations (the term structure). These shapes are not pricing errors — they encode the market's pricing of crash risk, event risk, and the mean-reverting nature of volatility, and they are themselves tradable.

Vertical Skew: IV by Strike

In equity index and single-stock options, lower-strike (put-side) IV is persistently higher than higher-strike (call-side) IV — the equity "smile" or "sneer"2.

Driver Mechanism
Crash fear / insurance demand Hedgers persistently buy downside puts, bidding up low-strike IV
Lognormal vs. real distributions Real markets crash harder than lognormal predicts; fat left tails raise OTM put value
Supply on the upside Covered-call writers add call supply, compressing upside IV
Asset-class variation The shape is not universal — commodity markets (e.g., grains) can skew the other way, with demand for upside (call) protection2

What the skew implies: the market is not pricing one volatility per underlying. It prices a distribution with fatter left tails than lognormal, and the steepness of the put skew is a live gauge of demand for protection — steepening in fear, flattening in complacency.

Horizontal: the Term Structure

Holding strike constant, IV varies across expirations2:

Shape Meaning Typical context
Contango (front < back) Calm: near-term vol expected low, longer-dated uncertainty priced higher; IV expected to rise toward its long-run mean Normal markets
Backwardation (front > back) Stress or imminent event: near-term fear dominates; front-month IV above back months Crashes, acute crises, pinned event dates

Front-month IV is the most reactive — the most-traded contracts, the smallest vegas — so the term structure steepens and inverts faster than longer-dated vols move2. Specific expected events (earnings, FDA decisions, Fed meetings) lift the IV of the specific expirations that span the event, creating bumps rather than smooth curves.

Events: the Rush and the Crush

Event risk is the cleanest lens on both shapes. Before a binary event, IV of the spanning expirations is bid up (the rush); once the event lands, uncertainty resolves and IV collapses (the crush) — sometimes 10–20+ points in minutes2. This is why comparing an option's IV before and after an event says little about "value": the term structure locally deflates around the event date even if nothing about the long-run vol regime changed.

Trading the Shapes

  • Skew is tradable, not just observable: ratio spreads, backspreads, and butterflies monetize the strike curve; Natenberg treats the skew as an input to choosing which options are relatively cheap vs. rich1.
  • Term-structure trades (calendars, diagonals) express views on the front/back relationship and event timing.
  • Practical screen from the IV/RV charts: when the whole curve is rich versus realized vol with no catalyst, short-vol structures benefit from both level and shape normalization; when IV is at historical lows and RV has been rising, long-gamma structures capture the catch-up3.
  • Caution: skew can steepen without the underlying moving — a short-strike/long-strike spread that looks "cheap" by average IV can still lose if the skew itself re-prices.

Links

Source Notes

  1. Natenberg, Option Volatility & Pricing, ch. 14 (bundle: ../option-volatility-and-pricing-bundle/topics/volatility.md). ↩

  2. Passarelli, Trading Option Greeks 2e, ch. 3 (bundle: ../trading-option-greeks/topics/volatility.md). ↩↩↩↩↩

  3. Passarelli, ch. 14 (bundle: ../trading-option-greeks/topics/volatility-charts.md). ↩