Implied volatility on options is a gauge of investors’ fears regarding the potential amplitude of future price movements in the underlying commodity or financial instrument. However, implied volatility is rarely evenly distributed. Sometimes, investors fear an upside risk more than a move down. At other times, investors might fear an extreme downside risk more than extreme upside move. 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 skew.
But what, if anything, does the skew tell us about the likely future direction of prices? For example, if options traders’ price a more extreme upside risk than an extreme downside move, do prices of futures tend to trend higher or lower? In other words, do markets take the cue and trend in the direction of options traders’ greatest fears, move in the opposite direction, or remain unaffected?
The answer, seemingly, depends on the commodity or financial instrument in question. To answer the question, we use CME Group’s new suite of volatility indexes (CVOL). The CVOL index for each commodity or financial futures uses a simple variance methodology that assigns equal weighting to strikes across the entire implied volatility curve. In addition to producing an overall CVOL number covering all strike prices, it also produces UpVol, the implied volatility on options with strikes above the current trading level of the market, and DownVol, the implied volatility on options with strikes below the current trading levels of the market. The difference between these numbers gives us the CVOL skew: UpVol – DownVol = CVOL Skew.
We then construct a diffusion index to normalize the degree of CVOL skew on a scale of zero to 100. For example, if the CVOL skew is the most negative that it has been over the past two years, then it gets a reading of zero. If the CVOL skew is the most positive that it has been over the past two years, it gets a reading of 100. If it’s exactly at its average for the past two years, it would get a reading of 50. (For a detailed discussion on the calculation of the diffusion index, please see the appendix below).
We then evaluate the returns of the futures contract in the three months following each CVOL skew diffusion index observation. For many commodities, including gold, silver, copper, West Texas Intermediate crude oil, ultra-low sulfur diesel (formerly heating oil) and gasoline, there has been a strong negative association between the 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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By: CME Group