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Ask the Institute

DATE: May 20, 2013

QUESTION:

Can you explain the term implied volatility skew?

ANSWER:
Standard option pricing models allow traders to input a value for an option, such that in return, they can obtain an implied volatility level. Option pricing models such as Black-Scholes assume a constant volatility level across all strikes and across all expirations. Pricing models often make the additional assumption that the implied volatility level used is equal to the realized volatility level of the underlying security.

However, the assumption of constant volatility across all strikes and expirations is not something that we see in real life. In reality, the implied volatility level may and typically does differ from one option strike to the next, and from strikes at one expiration to strikes in another expiration. This difference in implied volatility levels between one strike and another is referred to as implied volatility skew. To learn more about implied volatility skew, view this week's segment of "Ask the Institute."


CBOE Volatility Index (VIX)