Why does implied volatility show an inverse relation with strike price when examining option chains?

External question — Quantitative Finance Stack Exchange Author: Joseph Tanenbaum Original post: https://quant.stackexchange.com/questions/27 License: CC BY-SA 2.5 — https://creativecommons.org/licenses/by-sa/2.5/ Adaptation: HTML converted to plain text; contact email addresses removed. When looking at option chains, I often notice that the ( broker calculated) implied volatility has an inverse relation to the strike price . This seems true both for calls and puts. As a current example, I could point at the SPY calls for MAR31'11 : the 117 strike has 19.62% implied volatility, which decreaseses quite steadily until the 139 strike that has just 11.96%. (SPY is now at 128.65) My intuition would be that volatility is a property of the underlying, and should therefore be roughly the same regardless of strike price. Is this inverse relation expected behaviour? What forces would cause it, and what does it mean? Having no idea how my broker calculates implied volatility, could it be the result of them using alternative (wrong?) inputs for calculation parameters like interest rate or dividends?

External answer — Quantitative Finance Stack Exchange Author: prespbj Original post: https://quant.stackexchange.com/a/10262 License: CC BY-SA 3.0 — https://creativecommons.org/licenses/by-sa/3.0/ Adaptation: HTML converted to plain text; contact email addresses removed. you get a volatility skew by imposing a neumann-like barrier if market makers think a stock won't surpass a certain threshold, a skew is inevitable if one were to match the pricing under a barrier with the BS formula https://en.wikipedia.org/wiki/User:Barrieroption/sandbox