Volatility Smile in the Commodity Market

Follow us on LinkedIn

The volatility smile is a phenomenon observed in the options market where implied volatility tends to be higher for out-of-the-money (OTM) options compared to at-the-money (ATM) options. It refers to the graphical shape of the volatility curve, resembling a smile when plotted against the strike prices of options. The volatility smile suggests that options traders are willing to pay higher premiums for OTM options, indicating a higher perceived risk of extreme price movements in the underlying asset. This departure from a flat volatility curve challenges the assumptions made by the Black-Scholes option pricing model, which assumes constant and symmetric volatility across different strike prices.

Reference [1] proposed to use the new method developed by Carr and Wu in order to study the volatility smile of commodities. Specifically, the authors examined the volatility smile of the United States Oil ETF, USO.  They pointed out,

In this paper, we study the information extracted from the no-arbitrage Carr and Wu (2020) formula based on a new option pricing framework in the USO option market and investigate the predictability of the information in forecasting the future USO returns. The risk-neutral variance and covariance estimates can be obtained from the no-arbitrage formula under the new framework. We document the term structure and dynamics of the risk-neutral estimates which lead to a “U”-shaped implied volatility smile with a positive curvature.

The figure below shows the volatility term structure for the United States Oil ETF,

Volatility smile of the United States Oil ETF, USO

Volatility smile of the United States Oil ETF, USO

Usually, an equity index such S&P 500 exhibits a downward-sloping implied volatility pattern, i.e. a negative implied volatility skew. Oil, on the other hand, possesses a different volatility smile. This is because while equities are typically associated with crash risks, oil prices exhibit both sharp spikes and crashes, leading to a different implied volatility pattern. This highlights the importance of considering the specific characteristics and dynamics of different asset classes when analyzing and interpreting implied volatility patterns.

Let us know what you think in the comments below or in the discussion forum.

References

[1] Xiaolan Jia, Xinfeng Ruan, Jin E. Zhang, Carr and Wu’s (2020) framework in the oil ETF option market, Journal of Commodity Markets, Volume 31, September 2023, 100334

Further questions

What's your question? Ask it in the discussion forum

Have an answer to the questions below? Post it here or in the forum

LATEST NEWSA pair enjoyed pricey meals and bolted when it was time to pay. Their dine and dash ended in jail
A pair enjoyed pricey meals and bolted when it was time to pay. Their dine and dash ended in jail

LONDON (AP) — A Welsh couple who dined out on pricey meals and bolted when the bill came is now paying the price — behind bars. Bernard and Ann McDonagh were sentenced to prison on Wednesday for fraud after running up tabs they didn’t pay…

Stay up-to-date with the latest news - click here
LATEST NEWSKretinsky Says Royal Mail Needs Funds to Avoid ‘Deadly Spiral’
Kretinsky Says Royal Mail Needs Funds to Avoid ‘Deadly Spiral’

Czech billionaire Daniel Kretinsky, who plans to purchase the company that owns UK’s Royal Mail, says the British postal service needs new investment to be competitive.

Stay up-to-date with the latest news - click here
LATEST NEWSSaudi Arabia to Sell Aramco Stake That May Raise $10 Billion
Saudi Arabia to Sell Aramco Stake That May Raise $10 Billion

Saudi Arabia confirmed plans for a secondary share sale for its giant state-owned oil company in a deal that could raise over $10 billion for the kingdom as it seeks funds to pay for a massive economic transformation plan.

Stay up-to-date with the latest news - click here
LATEST NEWSHow to make money from medical research and donations
How to make money from medical research and donations

You can make good money from donating plasma or sperm on a regular basis. Other donations and scientific experiments can pay thousands of dollars.

Stay up-to-date with the latest news - click here
LATEST NEWSChristina Applegate's early MS symptoms show how the disease can be mistaken for everyday aches. What you need to know
Christina Applegate's early MS symptoms show how the disease can be mistaken for everyday aches. What you need to know

The faster people are diagnosed, the better the chance that medical intervention can help stave off the progression.

Stay up-to-date with the latest news - click here

Leave a Reply