If you don’t understand the most basic elements of volatility, especially implied volatility, you probably shouldn’t be using options on a regular basis in my view.
I am often struck by how many people I meet at seminars and seminars, who—when we start to talk about options—say something like, “I don’t understand those options.” And shortly there-after it’s usually followed-up with a comment like, “And they never make me any money.” There could be a variety of reasons for them to feel this way, and it’s important for the reader to understand before I go further that, there are frequent times in my career as a registered broker that I have recommended options with the express intent that I really didn’t want them to make money for the clients—that I was recommending them in order defend against a worst-case scenario…hoping all along that that worst-case scenario never developed or transpired. But I have always tried my best to communicate this to clients and subscribers before the actual transaction is enacted. Similarly, in the case of selling options, many times your specific goal in taking unlimited risk like these positions is expressly to have them wither and lose value. Making this point right off the bat, we can move forward with option volatility; and we will assume from here on out (unless otherwise noted), that the goal of a bought option position is to have it increase in value, or at least hold its value for a specified time. IT IS HERE THAT IMPLIED VOLATILITY HAS OFTEN BEEN EITHER MY BEST FRIEND OR MY WORST ENEMY IN THE RECOMMENDATIONS I’VE MADE TO CLIENTS & SUBSCRIBERS.
To get things started, we need to talk about what volatility means in the commodity futures & options market, as well as define what type of volatility we should be most concentrated upon: implied volatility or historical volatility. Below is a wonderful description which should help get us into the right frame of mind.
Ψ Important Point: I believe you will understand options much better if you accept immediately that what we are going to discuss is another language—and that, like a foreign language, you must first know what the words mean. Then and only then can you truly comprehend the language.
—From the FAO’s May, 2008 Food Outlook:
Measuring volatility: historical versus implied volatility. Volatility measures how much prices have moved or how they are expected to change. Historical volatility represents past price movements and reflects the resolution of supply and demand factors. It is often computed as the annualized standard deviation of the change in price. On the other hand, implied volatility represents the market’s expectation of how much the price of a commodity is likely to move in the future. The data upon which historical volatility is calculated may no longer be reflective of the prevailing or expected supply and demand situation. For this reason, implied volatility tends to be more responsive to current market conditions. It is called “implied” because, by dealing with future events, it cannot be observed, and can only be inferred from the prices of derivative contracts such as “options”.
An “option” gives the bearer the right to sell a commodity (put option) or buy a commodity (call option) at a specified price for a specified future delivery date. Options are just like any other financial instrument, such as futures contracts, and are priced based on the market estimates of future prices, as well as the uncertainty surrounding these estimates. The more divergent are traders’ expectations about future prices, the higher the underlying uncertainty and hence the implied volatility of the underlying commodity.
Does volatility matter? Prices of derivative commodities that are observed today of commodities which are traded in the major global exchanges are determined by underlying expectations, and uncertainties about such expectations, pertinent to the market and the commodity. Hence, implied volatility as reflected or inferred by the prices of derivative contracts is an important component of the price discovery process and is a barometer as to where markets might be headed.
ψ From this beneficial FAO material, we can draw an important conclusion to help us to move forward: When determining what options to buy or sell, and to help determine the pricing-matrix involved in this decision, implied volatility is the type of volatility that we should be most concerned. Why? Because, and this is very important, option valuation should be like futures, meaning “buy low & sell high”: only with options, you utilize the implied volatility to help gauge if you should be an option buyer (low implied volatility) or an option seller (high implied volatility). As the FAO information suggests, if market sentiment is becoming increasingly uncertain, implied volatility in the options is most likely going to rise. With that elevated implied volatility, futures prices go higher, and as a result, the premium on the option—its cost—increases. My typical advice to clients & subscribers: be more of a buyer of options when implied volatility and a seller of options when implied volatility is high.
Ψ The VIX Index—which tracks the S&P 500 Index options—will typically go down when the equities market is rallying; but in commodities it is the opposite. This becomes very important as we go forward in this blog on volatility.]
So, the natural next question is: what is “low” and “high” implied volatility?
Well, this “natural” question seems to get overlooked by many traders and hedgers, because it takes some digging to get to an answer. But that’s what I do—I analyze! So, let’s take a look at some charts below.
—From CME Group: Volatility Term Structure
—From My Real-time Quote & Options System:
- The first three charts depict the structure of implied volatility based upon the contracts. This means that, on the blue line in each chart, we see letters and a number at the end, such as OZCU6: this represents the September (U) 2016 contract (6) for electronic corn (OZC) volatility, and its structure until the next contract, December, takes-over (Z). And so on. This shows us that linking the contracts together like this, that current implied volatility drops off rapidly after the September contract for both corn & wheat, and it drops off rapidly after October in the soybeans (OZSX6). This suggests to the market, right now, that there is less uncertainty about the grain futures price–hence the dropping implied volatility–going forward. And, all other things being equal, this therefore suggests to the market that the supplies are not threatened, because, as we addressed with our comment denoted by Poseidon’s Trident in red above, that futures prices should have more pressure and go lower as we approach Autumn.
- If implied volatility does drop sharply in the corn & wheat as we approach Autumn, this becomes–again, all things being equal and ignoring time-decay for now–a better environment for buying options, while simultaneously a more poor environment for selling options.
- The last chart shows the 30-day Implied Volatility for ATM corn call options, and represents best in my view what most of us see when we look-up implied volatility for corn futures. This chart doesn’t show the term structure like the CME chart did; it shows the actual implied volatility as time has progressed–and as a result, it shows or reflects better, I think, what a “high” or “low” implied volatility for corn is historically going back to 2008–the heart of the Financial Crisis.
Putting It All Together:
Analyzing this last chart for clients and subscribers, I would suggest–based upon what we now know from this blog post–that, if a trader/hedger wants to forecast a corn rally of significance, then this chart would suggest the implied volatility for the 30-day corn call needs to go above 30% for more than just a month. Why? Because we see that this has only happened once since the 2012 drought. Remember, for commodities, typically a higher implied volatility = increased uncertainty = higher prices/greater risk premium.
Call or email me with questions on this, or email me with suggestions for what you would like in Part 2 of this series on implied volatility. MZ