Volatility Skew and the Option Smile

What Volatility Skew Means and Why It Matters

Volatility skew is the simple but powerful observation that options on the same underlying and the same expiry do not all trade at the same implied volatility. A far out of the money NIFTY put and a far out of the money NIFTY call can sit thousands of points apart from the spot, yet the put almost always carries the higher implied volatility. That gap is the volatility skew, and once you learn to read it you start to see the market's fear and greed priced directly into the option chain rather than hidden behind a single headline number.

Most new traders quietly assume there is one volatility for an index on any given day. There is not. The option chain holds dozens of strikes, and each one carries its own implied volatility. When you plot those numbers against the strike price for a single expiry, you rarely get a flat line. In Indian index options you usually get a downward sloping curve, steep on the put side and gentle on the call side. Understanding why that shape exists, and what it is telling you, separates traders who guess from traders who price.

This guide builds from the ground up. We start with what implied volatility actually is, then explain why it differs across strikes, the difference between a smile and a skew, the strong put skew in NIFTY and BANKNIFTY, how to read and measure it, what it signals about sentiment, the link to term structure, and finally the strategies that traders use to work with the curve rather than against it. Everything here is educational and is not financial advice. The worked numbers are illustrative examples you can test for yourself on a paper trading platform like First Plan India before any real money is ever involved.

Implied Volatility: The Number Inside Every Option Price

Every option price has two parts: intrinsic value and time value. Time value is where volatility lives. Implied volatility, or IV, is the volatility figure that, when fed into an option pricing model such as Black Scholes, makes the model's theoretical price equal the price the option is actually trading at in the market. In plain words, IV is the market's forecast of how much the underlying will move, expressed as an annualised percentage, backed out from the live premium.

IV is not the same as historical or realised volatility, which measures how much the underlying actually moved in the past. IV is forward looking. It blends every trader's expectation of future movement, every hedger's demand for protection, and every seller's willingness to supply it. When fear rises, buyers pay up for options, premiums swell, and the IV backed out of those richer premiums climbs even if the underlying has not yet moved at all.

India VIX is the most familiar example of implied volatility in the Indian market. Computed by the NSE from a basket of near month and next month NIFTY option prices, it expresses the market's expected NIFTY volatility over the coming thirty days as an annualised percentage. When India VIX jumps from 12 to 20 around an event, it is telling you that option buyers have bid up premiums across the chain. India VIX is a single summary number, but the option chain underneath it is far richer, because each strike has its own IV. The way those strike level IVs differ from one another is exactly what we mean by skew.

The original Black Scholes model assumes that volatility is constant: one number for every strike and every expiry. If that were true, a graph of IV against strike would be a perfectly flat line. The entire reason skew exists is that this assumption is wrong. Real markets do not move in the neat lognormal pattern the model assumes, and traders correct for that by quoting different volatilities at different strikes. Skew is, in a sense, the market patching the holes in a textbook formula with real money.

Why Implied Volatility Differs Across Strikes

If asset returns truly followed the smooth bell shaped lognormal distribution that the basic model assumes, every strike would share one implied volatility. They do not, because real returns have two stubborn features the model ignores: fat tails and negative skewness. Fat tails mean extreme moves, both up and down, happen far more often than a normal bell curve predicts. Negative skewness means the left tail, the crash side, is fatter and longer than the right side.

Because large down moves are more likely than the model assumes, deep out of the money puts have a genuinely higher chance of finishing in the money than the textbook says. The market knows this, so it charges more for those puts. A higher premium for the same strike, fed back through the pricing model, comes out as a higher implied volatility. That is the mechanical link: real world tail risk raises the price of tail strikes, and the model translates the richer price into a higher IV. The skew is the visible fingerprint of a distribution that is not actually lognormal.

On top of the statistics sits plain supply and demand. Large institutions, mutual funds and portfolio managers are structurally long the market, so they constantly buy downside puts as insurance. That steady hedging demand pushes put premiums, and therefore put IV, higher. On the call side the flow often runs the other way: many investors sell calls against their holdings to earn income, which adds supply and gently presses call IV down. The combination of fatter left tails and one sided hedging demand is why the curve tilts the way it does.

This is not a one off quirk. The skew in equity index options is remarkably persistent. It shows up day after day, year after year, in NIFTY, in the S and P 500, and in almost every major equity index in the world. The steepness changes with the mood of the market, but the basic downward tilt rarely disappears. A trader who treats every strike as if it shared one volatility is ignoring one of the most reliable structural features of the entire options market.

The Volatility Smile, the Skew and the Smirk

When you plot implied volatility on the vertical axis against strike price on the horizontal axis for a single expiry, the shape you get has a name. If both deep out of the money puts and deep out of the money calls carry higher IV than the at the money strike, the curve dips in the middle and lifts at both ends. That symmetric U shape is the volatility smile.

A pure, symmetric smile is most common in currency and some commodity markets, where a sharp move in either direction is equally plausible. Equity indices look different. There the left side of the curve, the puts, lifts much more than the right side, the calls. The result is less of a smile and more of a downward sloping line with a slight curl, which traders call a skew or a smirk. In a smirk, low strikes have the highest IV, IV falls as you move up through the strikes, and the far call wing sometimes ticks up only a little, or not at all.

This was not always the case. Before the crash of October 1987, equity options traded with something close to a flat volatility across strikes. That single day collapse, which the lognormal model said should almost never happen, permanently changed how traders priced downside risk. Ever since, equity index options have carried a built in premium for crash protection, and the put skew has been a permanent feature of the landscape. The smirk is, in effect, the market's long memory of how violently equities can fall.

It helps to keep the vocabulary straight. Skew, in the broadest sense, simply means IV is not flat across strikes. A smile is the symmetric U shape. A smirk, or reverse skew, is the asymmetric downward slope typical of equity indices, where puts are bid up more than calls. In Indian index options you will almost always be looking at a smirk, so when an Indian options trader says skew, they usually mean this put heavy tilt.

In equity indices the volatility curve is rarely a smile. It is a smirk, and that smirk is the market pricing its fear of a fall.

Put Skew in Indian Index Options: NIFTY and BANKNIFTY

NIFTY and BANKNIFTY are the two most heavily traded options markets in India, and both show a clear put skew. On a normal trading day, if NIFTY is near 24,000, the 22,000 put might carry an implied volatility several points higher than the 26,000 call, even though both strikes are a similar distance from the spot. The lower you go in strike, the higher the IV climbs. This put skew is the default state of the Indian index option chain, not a rare event.

Index skew tends to be steeper than the skew on individual stocks. The reason is correlation. In a sharp market fall, stocks do not drop independently; they fall together as fear spreads across the whole market. That correlated crash risk is concentrated in the index, so index puts carry an extra layer of protection demand that single stock puts do not. BANKNIFTY, being a concentrated basket of large lenders that move together, can show an especially lively skew around banking sector news, RBI policy and credit events.

A few India specific facts shape how this plays out in practice. NIFTY and BANKNIFTY options are cash settled, so there is no delivery of shares; profit or loss is paid in rupees against the closing index level on expiry. As an illustration, the NIFTY lot size is 65 and the BANKNIFTY lot size is 30, so a single point of premium is worth ₹65 on a NIFTY option and ₹30 on a BANKNIFTY option. The exchange revises lot sizes from time to time, so always confirm the current size from the latest NSE circular before you trade.

Expiry structure matters too. NIFTY offers weekly options that expire every Tuesday, plus a monthly contract that expires on the last Tuesday of the month. After SEBI rationalised weekly contracts in late 2024, weekly options now exist only on the NIFTY 50 index; BANKNIFTY trades on a monthly cycle only, also expiring on the last Tuesday. Very short dated weekly options often show a sharper, more jagged skew because a single event can dominate the few days left, while longer dated monthly options tend to show a smoother, more gradual skew driven by steady hedging. Comparing the weekly and monthly NIFTY chains is really comparing two different fear horizons.

Reading a Skew Chart: A Worked NIFTY Example

Numbers make this concrete. Suppose NIFTY is trading at 24,000 with about thirty days to the monthly expiry. A simplified snapshot of the option chain might show implied volatilities like these, read from the low strike at the top to the high strike at the bottom.

• 22,000 put, deep out of the money: IV around 18.0 percent
• 22,500 put: IV around 16.5 percent
• 23,000 put: IV around 15.0 percent
• 23,500 put: IV around 13.5 percent
• 24,000 at the money: IV around 12.5 percent
• 24,500 call: IV around 11.8 percent
• 25,000 call: IV around 11.2 percent
• 25,500 call, deep out of the money: IV around 10.8 percent

What the Skew Curve Is Telling You

Plot those points and the picture is unmistakable. The curve starts high on the left at the 22,000 put with an IV of 18.0 percent, slopes down through the at the money 24,000 strike at 12.5 percent, and keeps drifting lower to the 25,500 call at 10.8 percent. That downward slope from left to right is the put skew. The 22,000 put is priced as if NIFTY could be far more volatile than the 25,500 call assumes, even though the call is actually a touch closer to the money here. The market is paying up for downside protection and discounting upside speculation.

It helps to see what the IV difference means in money. Because each NIFTY point of premium is worth ₹65, even a couple of extra volatility points on the put side can add hundreds of rupees to the cost of each contract, and thousands across a multi lot position. A trader who buys deep out of the money NIFTY puts as a habit, without noticing they are paying an 18 percent IV against a 12.5 percent at the money IV, is quietly overpaying for insurance every single time.

The shape is not static. On a calm day the curve is gentle. As anxiety builds before an event, the left side lifts and the slope steepens; the 22,000 put IV might jump from 18 percent to 22 percent while the at the money barely moves. Watching the slope steepen or flatten day to day is one of the most direct ways to read whether the market is growing more fearful or more complacent, which is a theme we return to below.

What Really Drives Skew: Crash Risk, Leverage and Demand

We have touched on the drivers; now let us put them together properly. The first and biggest is the simple asymmetry of how markets move. Equities tend to grind higher slowly and fall quickly. Rallies build over weeks; crashes happen in days or hours. Because the speed and size of down moves dwarf up moves, the probability of a large loss is genuinely higher than the probability of an equally large gain over the same window. Option pricing reflects that reality by charging more for downside strikes.

The second driver is the leverage effect. A company funds itself with a mix of equity and debt. When its share price falls, the equity portion of its capital shrinks while the debt stays fixed, so the firm becomes more leveraged and its equity becomes mechanically more volatile. Falling prices and rising volatility therefore go hand in hand. Lower strikes correspond to a more leveraged, more volatile state of the world, so the market assigns them a higher implied volatility. Rising prices have the opposite, calming effect, which is part of why call IV sits lower.

The third driver is flow. Long only institutions buy index puts to protect portfolios, and that one directional demand is met by market makers who must be paid to take the other side of crash risk. To stay hedged, those market makers buy and sell the underlying as the index moves, and the cost and difficulty of hedging a fast falling market gets baked into higher put premiums. On the call side, persistent call selling for income adds supply and keeps a lid on call IV. The skew is the equilibrium price of all this hedging activity.

Finally there is gap risk. Indian markets can open far away from the previous close after overnight global moves, a surprise RBI decision, or sudden geopolitical news. A position that looked safe at 3:30 in the afternoon can be deep under water at the 9:15 open. Options that protect against gaps, mostly puts, must be priced for that jump risk, which no smooth model captures well. The extra premium for jump protection is yet another reason the put wing of the curve sits so high above the call wing.

Why Out of the Money Puts Cost More

Think of an out of the money index put as a fire insurance policy on your portfolio. You pay a premium today for a payout if disaster strikes. Just like fire insurance, the premium is set by how likely and how costly the disaster is, plus a margin for the insurer. Because a market crash is both plausible and expensive, and because so many people want the same cover at the same time, the premium, expressed as implied volatility, is high. Skew is simply the price of insurance rising as you ask for protection against worse and worse outcomes.

Suppose NIFTY is at 24,000 and you want to protect against a fall to 22,000 over the next month. The 22,000 put trades at an 18 percent IV, while a similar distance call, the 26,000 strike, trades at perhaps an 11 percent IV. The put is not more expensive because it is closer to the money; in this example the two strikes are roughly symmetric around the spot. It is more expensive because the market genuinely fears the downside more than it hopes for an equal sized upside. You are paying for that fear every time you buy protection.

This creates a recurring trap. Beginners often buy cheap looking far out of the money puts before an event, hoping for a big payoff in a fall. What they miss is that those puts already carry an inflated IV, so they are buying high volatility. If the feared move does not happen, or happens but is smaller than the priced in expectation, the IV collapses afterwards and the put loses value fast even if the index drifts down a little. Buying the most fear loaded strike on the chain is rarely the bargain it appears to be.

The same skew that punishes naive put buyers tempts put sellers. Selling that rich 18 percent IV put looks like collecting easy premium. Sometimes it is, but the high IV is there precisely because the tail risk is real. Sellers of deep out of the money index puts are being paid to absorb crash risk, and on the rare day the crash arrives, the losses can dwarf years of collected premium. Whether you sit on the buy side or the sell side, the lesson is the same: respect what the skew is telling you about risk.

What Skew Signals About Market Sentiment

Beyond pricing individual options, the shape of the skew is a sentiment indicator in its own right. A steep skew, where put IV towers over call IV, says the market is anxious and is paying heavily for protection. A flat skew, where the gap between put and call IV is small, says traders are relaxed and see balanced two way risk. By tracking how the slope changes over days and weeks, you get a read on the mood of the market that a single price chart cannot give you.

It is worth separating the level of volatility from the shape of it. India VIX tells you the overall level of expected NIFTY volatility. The skew tells you how that expectation is distributed across strikes. The two can move differently. India VIX might be calm near 12 while the skew quietly steepens, a sign that informed money is buying protection even though the market looks placid on the surface. A steepening skew under a low VIX is often a more useful early warning than the VIX alone.

Indian markets have a predictable calendar of events that move the skew: the Union Budget in early February, RBI monetary policy meetings, general election results, and the quarterly earnings of heavyweights like Reliance and HDFC Bank. In the run up to such events, demand for protection rises and the put wing lifts, steepening the skew. Once the event passes and the uncertainty resolves, that event premium drains out and the skew often flattens sharply, a move that traders call the post event volatility crush.

How do you use this as a learner? Start by simply watching the IV of an at the money NIFTY option alongside the IV of a put roughly 5 to 8 percent out of the money, day after day. When the gap widens, fear is building. When it narrows, complacency is setting in. You are not predicting the future, you are reading the price of fear that the market is publishing in real time. On a paper platform you can log these readings against what the index actually did next and learn the patterns without risking a single rupee.

Measuring Skew: Risk Reversals and the 25 Delta Metric

To compare skew across days, expiries and instruments you need to turn the shape into a number. The most widely used measure is the risk reversal. A risk reversal is the difference between the implied volatility of an out of the money call and an out of the money put chosen at the same delta, usually the 25 delta strikes on each side. Written simply, the 25 delta risk reversal equals the 25 delta call IV minus the 25 delta put IV.

Professionals anchor the measure to delta rather than to a fixed strike because delta automatically adjusts for how far out of the money an option is in volatility terms. A 25 delta put is roughly the same notion of out of the money whether the index is calm or wild, whereas a fixed strike drifts nearer or further from the money as the index moves. Using the 25 delta points on each wing gives a clean, comparable read of the asymmetry between the call side and the put side.

Take our NIFTY example. Suppose the 25 delta put carries an IV of 14.5 percent and the 25 delta call carries an IV of 11.5 percent. The 25 delta risk reversal is 11.5 minus 14.5, which is minus 3.0 volatility points. A negative risk reversal is the signature of a put skew: calls are cheaper than puts in volatility terms. The more negative the number, the steeper the skew and the more the market is paying for downside over upside. If that figure moved from minus 3.0 to minus 6.0 over a week, the skew has steepened sharply and the relative price of fear has roughly doubled.

Risk reversal is the headline measure, but you will meet others. Some traders quote skew as the slope of IV per 10 percent change in strike, and others as the difference between a fixed out of the money put IV and the at the money IV. Brokers and analytics tools may plot a skew chart directly, the very curve from our worked example. Whatever the format, they all describe the same thing: how much steeper the put side of the curve is than the call side. Pick one measure, track it consistently, and you will build a feel for what normal and extreme look like for NIFTY and BANKNIFTY.

Skew, Term Structure and the IV Surface

Skew describes how IV varies across strikes for one expiry. There is a second dimension to volatility: how IV varies across expiries for a given strike. That second pattern is called the term structure of volatility. Put the two together and you get the implied volatility surface, a three dimensional map with strike on one axis, time to expiry on another, and implied volatility as the height. Skew is a single slice of that surface; the surface is the whole landscape.

In calm conditions the term structure usually slopes gently upward: longer dated options carry slightly higher IV than short dated ones, a shape borrowed from the bond world and called contango. This makes sense, since more time means more room for surprises. Around a known near term event, the front expiries can spike above the later ones, an inverted shape called backwardation, because the market expects a burst of movement very soon that should settle down later. The NIFTY weekly versus monthly comparison often shows exactly this when a big event falls inside the weekly window.

The full surface is alive. On a quiet day it is smooth and gently tilted. In a sell off the whole surface lifts, the put wing of every expiry steepens, and the near dated part can invert as panic concentrates in the immediate future. Watching the surface rather than a single IV number is how serious volatility traders think, because it shows them where protection is cheap and where it is dear across both strike and time at the same moment.

A practical tool that sits alongside the surface is the volatility cone, which plots the historical range of implied or realised volatility for each tenor, from very short dated to longer dated, as bands of high, average and low. Comparing today's IV at each tenor against its own cone tells you whether current volatility is cheap or expensive by historical standards. Combine the cone for level, the term structure for time, and the skew for strike, and you have a complete picture of how the market is pricing risk.

Trading Implications: Strategies That Use the Skew

Once you accept that puts are structurally expensive and calls relatively cheap in index options, the strategy implications follow naturally. The general principle is this: try not to be a naked buyer of the richest, highest IV strikes, and look for structures that let you sell expensive volatility while buying cheaper volatility, or that simply spread your cost across strikes so the skew works for you rather than against you.

Vertical spreads are the first tool. In a bear put spread you buy a higher strike put and sell a lower strike put. Because of skew, the lower strike you sell carries a higher IV than the higher strike you buy, so you are selling richer volatility and buying cheaper volatility within the same trade. That makes the spread relatively less expensive than the outright put. The trade off is a capped payoff, but for many traders giving up the far tail in exchange for a cheaper, defined risk structure is a sensible bargain.

Put ratio spreads take the idea further: you might buy one nearer the money put and sell two further out of the money puts, using the rich IV of the deep strikes to finance the position, sometimes for zero cost or even a small credit. The danger is the naked extra short put at the bottom, so this is an advanced structure that demands strict risk control. A risk reversal does the opposite of buying protection: you sell the expensive put and use the proceeds to buy the cheaper call, creating a low cost bullish position. It is cheap precisely because of skew, but you carry the full downside of the short put.

The honest summary is that skew does not hand you free profit, it changes the relative attractiveness of structures. When skew is very steep, selling put spreads or constructing risk reversals can be relatively appealing because you are selling dear volatility, provided you respect the tail risk. When skew is unusually flat, buying protection or buying put spreads is comparatively cheap. The skilled trader chooses the structure that fits both their market view and the current shape of the curve, rather than reaching for the same trade every time.

• Bear put spread: buy a higher strike put and sell a lower strike put, selling the richer skewed volatility to lower your net cost.
• Bull put spread: sell a put credit spread when you expect the index to hold above a chosen level, accepting that skew trims the credit.
• Put ratio spread: finance a near the money put by selling extra deep puts, an advanced, high risk structure with naked tail exposure.
• Risk reversal: sell the expensive put to fund a cheaper call for a low cost directional view, carrying the full downside of the short put.

A Worked BANKNIFTY Put Spread, Step by Step

Let us walk through a defined risk trade that uses the skew, purely as an educational example. Suppose BANKNIFTY is trading at 52,000 and you have a mildly bearish view over the next few weeks. Outright buying a 50,000 put is expensive because, thanks to skew, it carries a fat implied volatility. Instead you build a bear put spread: buy the 51,000 put and sell the 50,000 put on the monthly expiry.

Imagine the 51,000 put trades at an IV of about 16 percent for a premium of 600 points, and the 50,000 put, lower and therefore higher on the skew at an IV of about 17 percent, trades for 380 points. Your net cost is 600 minus 380, which is 220 points. Because the BANKNIFTY lot size is 30 in this illustration, the cost per lot is 220 multiplied by ₹30, which is ₹6,600. That is your maximum loss, and it is fixed the moment you enter the trade.

The most you can make is the distance between the strikes minus what you paid: 51,000 minus 50,000 is 1,000 points, less the 220 points of cost, which leaves 780 points. At ₹30 per point that is ₹23,400 per lot of maximum profit, reached if BANKNIFTY closes at or below 50,000 on expiry. Your break even is the higher strike minus the cost, 51,000 minus 220, which is 50,780. Below that level at expiry the trade is in profit; above 51,000 you simply lose the 220 points you paid, and nothing more.

Notice what the skew did for you. The 50,000 put you sold carried a higher IV than the 51,000 put you bought, so you collected relatively richer volatility on the short leg. Compared with a hypothetical flat volatility world, the skew narrowed your net cost and improved the ratio of reward to risk on this defined structure. This is the practical payoff of understanding skew: not a magic edge, but a smarter way to assemble a trade so the curve works with you. Remember to add brokerage, STT and other charges discussed below, because on a small spread those costs genuinely matter.

Skew Is Not Free Money: The Variance Risk Premium

By now a tempting conclusion may have formed: if puts are always expensive, just sell them and pocket the rich premium forever. This is the single most dangerous misreading of skew, and it has ruined traders far more experienced than most beginners. The high IV on the put wing is not a market mistake waiting to be harvested. It is the price of bearing a real and occasionally enormous risk.

There is a genuine, well documented phenomenon called the variance risk premium: on average, implied volatility tends to run a little higher than the volatility that actually shows up, so option sellers do earn a small positive return over time for supplying insurance. But average is the trap word. The premium is collected in small, steady amounts during the many calm periods, and then handed back, often with interest, in the rare violent periods. The payoff profile of selling skew looks like picking up coins in front of a steam roller: pleasant most days, catastrophic on the wrong one.

This is why the risk curve of a short put position is so lopsided. Your profit is capped at the premium you collected, while your loss expands as the index falls, accelerating in exactly the crash scenario the skew was pricing. A trader who sells deep out of the money NIFTY puts for years can show a smooth, attractive equity curve and then lose multiples of those gains in a single gap down. The skew was never mispriced; it was paying you precisely because that day was always possible.

The mature way to think about skew is as fair compensation for risk, not as a free lunch. If you choose to be a seller of expensive volatility, you must size small, define your risk with spreads rather than naked options, keep cash aside for margin spikes, and accept that the bad day will eventually arrive. If you are a buyer, you must accept that you are usually paying up for protection and time your purchases for when skew is relatively cheap. Either way, respect for the tail is what separates traders who last from traders who blow up.

The high implied volatility on the put wing is the price of a risk that is rare, real, and occasionally ruinous.

Practising Skew Safely: Costs, India Rules and Paper Trading

Whatever you do with skew, costs decide whether a thin edge survives. In India, options carry several layers of charge. The Securities Transaction Tax, or STT, is levied at 0.1 percent of the premium on the sell side of an options trade, and at a higher rate on the settlement value if an in the money option is exercised at expiry, so it usually pays to square off rich positions before expiry rather than letting them go to exercise. On top of brokerage there is an 18 percent GST charged on the brokerage and on the transaction charges, plus exchange fees, SEBI charges and stamp duty. For a small spread these add up and can quietly turn a marginal trade into a loss.

Indian index options are cash settled, so you never take delivery; the exchange pays or collects the difference in rupees against the settlement value on expiry. Cash equity trades settle on a T+1 basis, meaning shares and money change hands one working day after the trade. NIFTY offers weekly options expiring every Tuesday plus a monthly contract on the last Tuesday, while BANKNIFTY now expires only monthly, also on the last Tuesday, after the 2024 rationalisation of weekly contracts. Knowing exactly when your options expire, and that index options settle for cash, prevents nasty surprises around expiry day when skew and time decay both move fastest.

Some readers also trade crypto options or futures on offshore venues. Be aware that in India, gains from virtual digital assets are taxed at a flat 30 percent with no set off for losses, and a 1 percent TDS applies on transfers above the prescribed threshold. The skew concepts in this article apply to crypto options too, often with an even wilder shape, but the tax treatment and the platform risks are very different from regulated NSE products. Treat anything outside the regulated Indian exchanges with extra caution.

The safest way to internalise skew is to watch it and trade it without money on the line. On a paper trading platform such as First Plan India you can pull up the NIFTY and BANKNIFTY chains, note the IV at each strike, plot the skew, compute a simple risk reversal, place hypothetical spreads, and track how the curve and your positions behave through calm days and event days alike. Do this for a few expiry cycles and the abstract idea of skew becomes an instinct. This article is educational and is not financial advice; use it to learn, test everything for yourself, and never risk capital you cannot afford to lose.

Frequently asked questions

What is volatility skew in simple terms?

Volatility skew is the pattern where options on the same underlying and the same expiry trade at different implied volatilities depending on their strike price. In Indian index options such as NIFTY, lower strike puts usually carry higher implied volatility than higher strike calls. The skew exists because the market fears a sharp fall more than it expects an equal sized rise, so it charges more for downside protection.

Why do put options have higher implied volatility than calls?

Equity markets tend to fall faster and harder than they rise, so large down moves are more likely than the basic pricing model assumes. Institutions also constantly buy index puts as portfolio insurance, which pushes put premiums and therefore put implied volatility higher. The leverage effect adds to this, since falling prices make companies more leveraged and more volatile. Together these forces lift the put wing of the curve above the call wing.

What is the difference between a volatility smile and a volatility skew?

A volatility smile is a symmetric U shape where both deep out of the money puts and calls carry higher implied volatility than the at the money strike, and it is common in currency markets. A volatility skew, or smirk, is the asymmetric downward sloping shape typical of equity indices, where puts carry much higher implied volatility than calls. In NIFTY and BANKNIFTY you will almost always see a skew rather than a true smile.

What does a steep volatility skew mean?

A steep skew means the gap between put implied volatility and call implied volatility is large, so the market is paying heavily for downside protection. It usually signals rising fear or strong hedging demand, often ahead of events like the Union Budget, RBI policy or major earnings. A flattening skew suggests complacency or a more balanced view of risk. Tracking the slope over time is a useful sentiment gauge.

How do you trade volatility skew?

Most skew based trades try to sell relatively expensive volatility and buy relatively cheaper volatility, or to spread the cost across strikes. Common structures include bear put spreads, bull put credit spreads, put ratio spreads and risk reversals. The aim is to let the curve work for you rather than buying the single richest, highest IV strike outright. These are educational examples, not advice, and the riskier structures require strict position sizing.

Does NIFTY have a volatility skew?

Yes. NIFTY index options show a clear and persistent put skew on almost every trading day, where lower strike puts carry higher implied volatility than higher strike calls. BANKNIFTY shows the same pattern, often even more lively around banking news and policy events. The skew steepens when fear rises and flattens when the market is calm, but the downward tilt rarely disappears entirely.

What is a 25 delta risk reversal?

A 25 delta risk reversal is a single number that measures skew. It equals the implied volatility of the 25 delta call minus the implied volatility of the 25 delta put. For equity indices like NIFTY this number is normally negative, because puts carry higher implied volatility than calls. The more negative it is, the steeper the skew and the more the market is paying for downside protection relative to upside.

Is selling expensive index puts because of skew profitable?

On average, option sellers earn a small positive return called the variance risk premium, because implied volatility tends to run slightly above realised volatility. However, that premium is collected in small amounts during calm periods and can be lost many times over in a single crash, since a short put has capped profit and large, accelerating losses. Selling skew is compensation for genuine tail risk, not free money, and it demands strict risk control.