Tuesday, August 12, 2008

Crude Oil Volatility Slides with Crude Prices

Based on the large number of Google searches that have recently been landing on the blog, there is considerable interest in the CBOE’s new “Oil VIX” or crude oil volatility index (ticker OVX), which was launched exactly four weeks ago today.

While it is still too early to pluck much in the way of useful conclusions from the OVX, I have included a chart of the new volatility index below. So far what may surprise most newcomers to crude oil volatility is that the OVX has fallen in concert with crude oil prices (as measured by the USO crude oil ETF). My analysis of USO options suggests that crude oil implied volatility and the price of the underlying are likely to be largely uncorrelated going forward, which is in sharp contrast to the strong negative correlation between equities and their corresponding volatility indices, such as the VIX, the VXN, and the RVX.


Michael S said...

Bill - interesting find with the lack of correlation between OVX and the crude oil ETF. I wonder if the reason could be related to the fact that the optimism/panic dynamic that exists in the VIX (that you wrote about here: http://vixandmore.blogspot.com/2008/07/implied-volatility-and-magnitude-vs.html) is turned on its head with oil.

Should a catastrophic world event occur, equity markets will spike down, but oil markets will spike up. That would imply then that oil prices and the OVX should be positively correlated, but then there's the additional greed/fear dynamic of folks trading oil that would sort of balance that out.

Hope my logic makes sense. Just some ramblings...


jft said...

As Micheal said; isn't it more likely that the correlation is positive?
A clue should be given by the shape of the skew, of which I know noting in oil options. If the skew is upward sloping - higher vol for higher strikes - my guesstimate for the correlation between OVX and underlying would be positive over time. This would also, normally, as far as I understand probably mean a negative correlation between OVX and VIX. However I'm speculating; I know nothing about oil trading so it would be very interesting to see your comments on this issue.

Bst rgrds,


Anonymous said...

jft, it has everything to do with the skew. One thing I am not sure of in commodities is does that skew switch depending on perceived supply or demand risks? If it did then obviously that means there would be no static relationship between volaitilty and price.

Anonymous said...

Well said, Anonymous. It has everything to do with the skew. If there were no perceived correlation between the underlying and vol, then the implied volatility would be flat across all strikes for a given expiry.
In equity options, there is often what is called a 'smirk' -- i.e. implied vols on OTM puts are higher than ATM options.
In other markets (i.e. commodities, rates, FX, etc.), the vol skew can be U-shaped. In this case, the relationship between vol and the underlying is harder to model. A test of linear correlation between vol and the underlying will give misleading results.
Lack of correlation does not mean the two are independent...

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