The theory that options that are deeply out-of-the-money tend to have higher implied volatility levels that at-the-money options. Volatility skew measures and accounts for the limitation found in most options pricing models and uses it to give the tra der an edge in estimating an option's worth.
See Also:
Volatility: A measure of the fluctuation in the market price of the underlying security. Mathematically, volatility is the annualized standard deviation of returns (annualized standard deviation of a stock's daily price changes). Volatility is a primary determinant in the valuation of options premiums and time value. There are two basic kinds of volatility, implied and historical (statistical). Implied volatility is calculated by using an option pricing model (Black-Scholes for stocks and indices and Black for futures). Historical volatility is calculated by using the standard deviation of underlying asset price changes from clos e to close trading going back 21 to 23 days.
