You're skewed, or perhaps even likely to be skewered, if you don't understand anything about the skew of an option. The skew, also known as the volatility skew, tells you when one option is expensive in relationship to another.
Implied volatility is one of the inputs into an option's price. Not all options on a single underlying have the same implied volatility (IV), creating a difference or a skew. Without a skew, the Black-Scholes model for options' prices would just input the same IV into each calculation.
With a skew, some options will be skewed in relationship to another, being either more or less expensive than would be expected. Because of this skew, traders perhaps ought to retool their thinking about implied volatility (IV). Turn your thinking around. Don't think of implied volatility only as an input into the options' pricing models: think of it also as an output after market forces determine the price of an option.
Options' prices sometimes rescale the implied volatility. The rescaling better reflects the market's view about how volatile the underlying's moves might be. How is this rescaling accomplished? One example might occur if traders are worried about a big downside move. They'll buy puts and a sort of bidding war for puts ensues, with puts in demand. Put prices go up and this, in effect, rescales the implied volatility since other inputs such as the days to expiration remain steady.
As McMillan notes in Options as a Strategic Investment, in normal times, the skew usually takes on a characteristic pattern. As www.optionseducation.org, the educational arm of the Options Clearing Council, and other sites note, that characteristic pattern for options with the same expiration date often forms a smile shape when plotted, such as the one found at Investopedia's site.
Chart of Volatility Smile, from Investopedia:
This smile should be interpreted to say that at-the-money options generally possess lower implied volatilities than either in-the-money or out-of-the-money options.
This smile shape did not always exist for American equity options, however. As Lawrence McMillan pointed out in Options as a Strategic Investment (840), this skew instated itself only after 1987 when the skew of puts and calls was permanently changed.
The reason for the skew is buried in some tenets of the option pricing model. That model incorporates an assumption about the distribution of stock prices, called a log-normal distribution, that isn't quite accurate. That model says that it's as possible that prices will move down as up, but the "log" part of the "log-normal" comes from the fact that the underlying's prices can't move below zero, among other reasons. As one webinar presenter, Brian Overby of the CBOE, has said, tongue-in-cheek, some equities have tried moving below zero, but none have succeeded. So, although we intuitively understand that Ford's stock, quoted at $2.66 as of the close on December 4, can move up as easily as down, we also intuitively understand that while it can move up to $6.66, gaining $4.00, it can't move down $4.00.
Also, most sources comment that the log-normal distribution doesn't give a high enough probability of big moves to accurately reflect real-life trading patterns. That became particularly apparent after 1987, when the volatility skew was permanently changed, as McMillan and others have noted. One can only imagine that this last year's market behavior has only cemented the permanency of that skew that went into effect after 1987.
The smile produced isn't always quite so perfect or symmetrical. As the OIC's explanation notes, that smile is sometimes more of a smirk than a smile. This might happen if market participants believe there's more risk to the upside or downside, so that the implied volatility in either puts or calls turns higher. We also intuitively understand that while an equity can move one direction as easily as another, times exist when market participants believe that it's more likely to move in one direction than the other. Hence, the smirk.
It's important to understand that the skew shown on an equity chart might be quite different than one shown on a commodity chart. The way options are used in each market impacts those skews. Since 1987, out-of-the-money puts may be used to hedge portfolios and so may maintain their prices better--hence, having higher relative implied volatilities--than out-of-the-money calls. In the commodity market, however, options may be used differently. In some commodity markets, out-of-the-money calls are used to hedge against higher commodity prices, so those calls may maintain their prices--and, hence, higher IV's--than out-of-the-money puts.
Thus, some markets tend to have a forward or positive skew, a skew in which IV's increase at the higher option strikes. On page 186 of Profit with Options: Essential Methods for Investing Success, Lawrence G. McMillan notes that in the grain option markets and sometimes the metals markets, a forward skew often exists, and it sometimes does in other commodity markets such as sugar, cocoa and coffee. Other markets have a reverse or negative skew. Especially during times when there's much concern about sharp downside move, many U.S. equity options have a reverse or negative skew.
The previous discussion has centered on the skew that can be found in all the options with the same expiration date. This is a strike skew. Skews also exist between the front-month options of an underlying and the back-month options, and those skews become important in combination trades such as calendars. These are time skews. To trade a calendar, a trader sells a front-month option and buys a further-out, back-month option in the same underlying, at the same strike. Generally, the calendar trader hopes to sell an option with a higher volatility and buy one with a lesser volatility. Any increase in volatility then benefits the calendar trader, but this also helps assure that the calendar trader is selling a relatively expensive option and buying a relatively inexpensive one.
As Dan Sheridan and others note, however, the calendar trader doesn't want to see too big a skew, as that alerts the calendar trader that market participants expect something to happen before the front-month option expires that will change prices in a big way. Often that "something" is an earnings announcement. In the case of a pharmaceutical, it might be an impending FDA decision. A tech company might be in as-yet-undisclosed merger talks. In the case of a commodity, a harvest or OPEC announcement may be expected. Something that might have unexpected results is anticipated, though, and the trader has been offered a warning.
In his webinars and seminars, Dan Sheridan suggests that calendar traders might want to avoid calendars in instances when the front-month ATM option's IV is more than four points above the back month's. Something is up in these instances and calendars are hurt by both a decrease in IV and too big a swing in price.
Not all traders want to trade calendars. However, noticing those skews between ATM options with different expirations might still be helpful. The trader who sees something strange happening in the skew of options for an underlying may be able to determine something about the market perception that isn't yet apparent in the underlying's price. Furthermore, they may also be able to determine something about the timing of the development that is skewing the options' price out of their usual shape. If JAN options show an abnormal skew but FEB ones have settled into a more normal one, the unforeseen event that is beginning to impact the normal skew may be taking place before JAN expiration, for example.
Many brokerages allow traders to look at IV values for each contract in an options chain. IVolatility.com also has that capability as well as providing various versions of skew charts, all for a monthly fee. Not all traders will need to or can capitalize on this amount of detail, but it is important to have a basic idea of the skew and what it might be showing. This helps options traders avoid buying temporarily expensive options and selling cheap ones, when they want to be doing the opposite.