The implied volatility of options is a measure of investors’ concerns about the potential amplitude of future price movements in the underlying commodity or financial instrument. However, implied volatility is rarely evenly distributed. Sometimes investors fear upside risk more than downside. At other times, investors might fear extreme downside risk more than extreme upside. The difference between the implied volatility of options with strike prices above and below the current trading price of the underlying instrument is defined as the implied volatility difference.
But what, if anything, does the bias tell us about the likely future price path? For example, if options traders price in more extreme upside risk than extreme downside, do futures prices tend to trend up or down? In other words, are the markets taking the signal and trending in the direction of options traders’ biggest fears, moving in the opposite direction, or staying unaffected?
The answer appears to depend on the commodity or financial instrument in question. To answer the question, we use CME Group’s new suite of volatility indices (CVOL). The CVOL index for each commodity or financial futures contract uses a simple variance method that assigns equal weights to strikes across the implied volatility curve. In addition to generating an overall CVOL number that covers all strike prices, it also calculates UpVol, the implied volatility of options with strike prices above the market’s current trading level, and DownVol, the implied volatility of options with strike prices below the current trading level Market. The difference between these numbers gives the CVOL skew: UpVol – DownVol = CVOL skew.
We then create a diffusion index to normalize the degree of CVOL offset on a scale from zero to 100. For example, if the CVOL offset is as negative as it has been in the last two years, it will be zero. If the CVOL offset is as positive as it has been over the past two years, it will be given a value of 100. If it is right on the average over the last two years, it would be given a value of 50. (For a detailed discussion on the calculation of the Diffusion Index, please see the appendix below.
We then assess the futures contract’s returns over the three months following each observation of the CVOL Skew Diffusion Index. For many commodities, including gold, silver, copper, West Texas Intermediate crude, ultra-low sulfur diesel (formerly heating oil), and gasoline, there is a strong negative correlation between CVOL skew and subsequent three-month returns in the futures markets. From 2007 to 2023, when traders feared upside risk more than downside volatility, prices tended to fall. When traders feared downside risk more than upside volatility, prices in these markets tended to rise (Figures 1-6). The same is true, albeit to a lesser extent, for certain other markets including soybean meal and the AUDUSD exchange rate (Figures 7 and 8).
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