Skew Trades: Risk Reversal vs Butterfly

Plot implied volatility against strike for options on the same expiry, and equity index options almost never come out flat — out-of-the-money puts typically trade at higher implied volatility than out-of-the-money calls, a pattern called skew, left over from the 1987 crash after which the market permanently began pricing crashes as more likely than a simple model would suggest. This shape has two separate features worth trading on their own: which side is more expensive (the tilt), and how expensive the wings are relative to the middle (the curvature).

A risk reversal isolates the tilt: buy a call, sell a put (or vice versa) at equal distance from the money. A butterfly isolates the curvature: buy the wings, sell the body, profiting from how rich or cheap the tails are relative to the center, without taking a view on which side is richer.

Two structures, two separate bets

A risk reversal, say buying a 25-delta call and selling a 25-delta put, is a bet that the skew will flatten (calls cheapen relative to puts, or the trader collects the initial tilt as it normalizes) — and it also carries directional exposure to the underlying, since a long call/short put combination behaves similarly to being long the stock. A butterfly, buying a wing on each side and selling two of the at-the-money option, is closer to direction-neutral: it wins if the wings are overpriced relative to the body and the market settles into the middle, and loses if a big move validates the wings' extra cost.

Worked example

A one-month index skew shows the 25-delta put at 22% implied volatility, at-the-money at 18%, and the 25-delta call at 16%. A trader believes calls are unusually cheap relative to puts and puts on a risk reversal: sell the put, buy the call, at roughly zero net premium (skew trades are often structured this way, since the put's higher implied vol makes it pricier, offsetting the cheaper call).

If, over the following weeks, the skew flattens — the put's implied volatility falls to 19% and the call's rises to 18%, with the at-the-money roughly unchanged — the position gains, because the option the trader is short (the put) got cheaper relative to the one they're long (the call), independent of where the underlying actually finished, provided the position was managed to stay close to delta-neutral against the underlying's drift.

What this means in practice

Skew trades are a core tool for volatility desks isolating a view on the shape of the smile rather than its level, and they matter beyond pure trading: skew is a direct input to how exotic and structured products (like the put-spread collars and buffer funds used elsewhere in options strategy) are priced, since those structures buy and sell options at different strikes whose relative cost depends entirely on the skew shape at the time.