Skew and Term Structure

Implied volatility isn’t one number. Every strike and every expiration has its own, and the pattern they form says a lot about the backdrop. Two shapes matter most. Skew is how IV changes across strikes for one expiration. Term structure is how at-the-money IV changes across expirations. Put them together and you get the volatility surface. Changes in these shapes show how nervous the options market is, which is useful context for every level on the map. This lesson reads both shapes and connects them to dealer hedging.

The smile and put skew

Plot IV against strike for one expiration and you get a curve often called the volatility smile. For stock indexes, the curve leans: downside puts carry higher IV than calls the same distance above price. That tilt is put skew. It reflects steady demand for portfolio protection and the market’s memory of crashes; index skew became pronounced after the October 1987 crash. Single stocks often show a flatter, more symmetric smile, and during speculative rallies the call side can carry the higher IV. To measure skew, compare IV at strikes equally far from price, and watch how that gap changes over time. Many professionals compare by delta instead of dollars, for example a 25-delta put against a 25-delta call, so readings stay comparable as price moves. A steepening skew means protection is getting pricier faster than at-the-money IV. It shows what traders are paying for insurance, not what will happen next; steep skew can last for months without a crash.

Term structure: calm slopes up, stress inverts

Now plot at-the-money IV by expiration, from nearest to furthest. In calm markets the curve usually slopes upward: near-term volatility is low, and longer-dated options price in the chance that it climbs back toward its long-run average. That shape is often called contango. When near-term IV jumps above longer-dated IV, the curve is inverted, also called backwardation. For an index, an inversion with no scheduled event often accompanies a sell-off: traders are paying up for protection now rather than later. Many traders compare Cboe’s VIX, a 30-day measure, with its three-month cousin, VIX3M; a VIX above VIX3M is an inverted reading. The VIX is calculated from SPX option prices across a wide range of strikes, so it carries some of the skew as well as at-the-money IV. The levels also translate into moves: divide annualized IV by 16 for a rough one-standard-deviation daily move (a year has about 252 trading days and √252 ≈ 15.9, rounded to 16; √256 is exactly 16, which is where the round number comes from), so 34% IV implies daily swings of about 2%, around $10 on a $500 index, against about $5 at 16%. Inversions also appear before known events. A single stock’s front-month IV rising before earnings is normal event premium, not market-wide stress, and it usually falls back afterward in an IV crush.

Remember that IV is a market price, not a promise. It blends traders’ expectations of movement with a premium for bearing risk, which is why implied volatility tends to run above the volatility that follows, on average (volatility risk premium). Skew and term structure connect to the positioning map through vanna. In index sell-offs, put IV usually rises as price falls. Under the dealer-side sign assumption, that grows the delta of the out-of-the-money puts dealers are modeled as short, which adds hedge selling on top of gamma hedging. When the stress fades, IV compresses and the same effect can turn into buying. Skew, term structure and the gamma regime often move together: rising put IV, an inverting curve and a slide below the Flip Line often show up together in a nervous backdrop. Each comes from a model or a market price, so each can be noisy on its own, and none of them is a timing tool.