Volatility skew and term structure: reading the shape, not the level
One symbol does not have one implied volatility. It has a surface across strikes and expiries, and the shape of that surface carries information the headline number destroys. Why index puts cost more, and what an inverted term structure means.
When a screen displays "IV: 28%" for a symbol, it has made a choice on your behalf. There is no single implied volatility for an underlying. There is a different one for every strike and every expiry, and the shape of that surface is where most of the information lives.
Two slices of it are worth knowing well: skew across strikes, and term structure across time.
This assumes you know what implied volatility is.
Skew: why downside options cost more
Take every option on the same underlying expiring on the same date, and plot implied volatility against strike. Under the original Black-Scholes assumptions that plot would be flat, because the model assumes one volatility for the underlying.
It is not flat. For equity indices it slopes down and to the right: lower strikes carry higher implied volatility. Out-of-the-money puts are more expensive, in volatility terms, than out-of-the-money calls.
This shape is often called the skew or the smirk. In currencies and some commodities the shape is closer to a symmetric smile, with both wings elevated.
Three explanations are usually given, and they are not mutually exclusive.
Crash risk is real and asymmetric. Equity indices fall faster than they rise. A distribution with a fat left tail should price left-tail options above what a normal distribution implies, and that is exactly what the market does.
Protection has natural buyers and few natural sellers. Institutions hold long equity and buy puts against it. That is persistent one-directional demand for a specific part of the surface, and demand raises price.
Volatility rises when markets fall. The two are negatively correlated, so a downside strike is not only more likely to be reached than a lognormal model says, it is likely to be reached in an environment where volatility itself has increased.
Worth knowing: this shape appeared after October 1987. Pre-crash equity option surfaces were far flatter. The skew is the market pricing a lesson.
Reading the steepness
The level of the surface tells you how expensive optionality is. The slope tells you something different: how much more the market charges for downside than for upside.
A steepening skew means downside protection is getting relatively dearer, which is usually demand for hedges. A flattening skew means that demand is easing, or that call buying is bidding the other wing.
The honest caveat is that skew is a positioning and demand read, not a forecast. Steep skew is frequently described as the market predicting a crash. It is more defensible to say the market is charging more for crash insurance, which is a statement about the price of protection and about who wants it.
Term structure: the same question across time
Now hold the strike near the money and plot implied volatility against time to expiry.
Contango is the normal shape: longer-dated options carry higher implied volatility than short-dated ones. This makes intuitive sense. More time means more opportunity for the unexpected, and near-dated volatility can be observed almost directly while distant volatility must revert to some long-run average.
Backwardation is the inverted shape: near-dated implied volatility exceeds longer-dated. This is the stress signal. It says the market expects turbulence now, concentrated in the immediate future, and expects conditions to settle after that.
Backwardation is the more informative of the two states precisely because it is less common. A market in contango is telling you very little. A market in backwardation is telling you that something specific and near-term is being priced.
The event effect, which is not a signal
One pattern gets misread constantly.
Ahead of a scheduled event, the expiry that spans the event shows elevated implied volatility relative to the expiries around it. Earnings, a central bank decision, a court ruling.
That bump is not information. It is a known binary event being priced, and it is entirely predictable from a calendar. The expiry that contains the event is more valuable, so it costs more, so its implied volatility is higher.
The corollary is the volatility crush. Once the event passes, that expiry's elevated IV collapses toward the surrounding surface, because the uncertainty it was pricing has resolved. This happens whether the stock moved a lot or not at all, which is why a correct directional call can still lose money on a long option through an event.
What the shape gives you that the level does not
The headline IV number tells you whether optionality is expensive. The shape tells you where and when it is expensive, and those are the questions that distinguish a market pricing generalised uncertainty from one pricing a specific fear on a specific horizon.
An elevated level with flat skew and contango is a market that has repriced uncertainty broadly. An unchanged level with steepening skew and backwardation is a market that is calm in aggregate and specifically worried about the downside, soon. Those are different situations that the same headline number describes identically.
The caution that applies to all of it
Everything above is a description of prices. The surface is a real-time record of what participants are willing to pay for different kinds of optionality, and that is genuinely informative about demand, positioning and the market's assessment of risk.
It is not a forecast, and the historical record on using surface shape to predict direction is far weaker than the confidence with which it is usually presented. The shape is well-founded as a read on what is being priced. Treat any leap from there to what will happen as a separate claim requiring separate evidence.
Next: the expected move and what the straddle is actually telling you.