Volatility skew

Defining 'Volatility skew'

When it comes to option trading with cryptocurrencies, the term 'Volatility skew' might come across as a complex concept to many. Put simply, volatility skew refers to the disparity in implied volatility for options contracts that are identical, but have different strike prices. But let's break it down further to ensure the concept is crystal clear.

Understanding Implied Volatility

Firstly, it's important to understand the concept of implied volatility. In the world of options trading, implied volatility reveals the expected fluctuation of a cryptocurrency's price. The higher the implied volatility, the more traders anticipate a cryptocurrency's price to swing wildly in either direction.

Analyzing Volatility skew

Now, connect this with the concept of the volatility skew. In a perfect market, regardless of the strike price of an option, the implied volatility remains constant. However, we don't live in an ideal world and this is where the 'volatility skew' comes into effect. It represents the difference in implied volatility based on the strike price of the option. Volatility skew can either be positive or negative.

Types of Volatility Skew

In the trading world, there are two main types of volatility skew namely: the smile and the skew. The smile refers to a situation where both OTM (Out of the Money) and ITM (In the Money) options have higher implied volatility compared to ATM (At the Money) options. The skew, on the other hand, is where OTM options have a higher implied volatility than ATM or ITM options. Cryptocurrency traders often use these forms of skews as signals for trading strategies.

Impact of Volatility Skew

The volatility skew presents valuable insights into the market's sentiment about the future performance of a cryptocurrency. A higher implied volatility for OTM options suggests that traders expect large price swings, indicative of high risk or potential high reward situations. Therefore, understanding and tracking the volatility skew can be a critical tool for an options trader.

Conclusion

In summary, the term volatility skew is an important concept in the realm of option trading with cryptocurrencies. It offers a visual representation of the market's expectations of future volatility and can greatly aid in making informed trading decisions. As with all trading concepts, a keen understanding and practical application of the volatility skew can significantly enhance your trading strategy, optimizing potential gains and mitigating potential risks.