How to Trade Volatility Skew: The Pricing Difference Between Call Spreads and Put Spreads
At tastytrade, our foundation is selling implied volatility.
But stocks don’r just have differing implied volatilities (IV). They also have differing strikes and expirations. And across the options chain, this varying implied volatility at different strikes creates the volatility skew in the market. Strategically, this can have a significant impact on pricing, just as we observe with the very basic standard vertical spread.
Vertical spreads—both call spreads and put spreads—are great strategies for newer traders or for anyone looking to define the risk on a trade. Whether you’re looking to play the market higher or lower, a vertical spread can allow you to express that directional bias while knowing your total risk in the trade. That’s a huge benefit from a risk management standpoint.
But anyone who trades vertical spreads will quickly notice that put spreads often trade relatively cheaply, and call spreads often trade relatively rich. Case in point, for the same distance out of the money (OTM), you will often see the put spread selling for a lower credit than the call spread on a given stock, in a given expiration cycle.
So, even though you essentially have the same amount of buffer between where the stock price is and where you place the short strike on your short vertical spread, the call spread is offering a premium seller a better entry price than the put spread.
So why is this happening? The simple answer is volatility skew.
The default setting in the markets, especially for the major indexes, is that IV rises as you move farther OTM on the put side, and the IV falls as you move farther OTM on the call side. As a result, the IV you are buying and the IV you are selling inside a vertical spread is not the same, and the difference ends up increasing the credit on call spreads and decreasing the credit on put spreads.
If the IV is dropping on the call side as you move OTM, then the IV you are selling with your short call will be higher than the IV you are buying with your long call. That’s because OTM short verticals are always set up with the short strike less OTM (closer to the stock price) than the long strike. So, with a short call spread, you end up “selling high and buying low” in regard to IV, and it ultimately gives you a better entry price.
Conversely, with IV rising on the put side as you move OTM, then the IV you are selling with your short put will be lower than the IV that you are buying with your long put. This is because, again, with a short vertical, you are selling a strike that’s less OTM and buying a strike that’s farther OTM. Because IV rises on the put side as you move farther OTM, you end up “selling low and buying high” with your put spread, which drags down the entry price a premium seller can collect.
Jim Schultz, a quantitative expert and finance Ph.D., has been trading the markets for nearly two decades. He hosts From Theory to Practice, Monday-Friday on tastylive, where he explains theoretical trading concepts and provides a practical application of those concepts to a trading portfolio. @jschultzf3
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