CME’S CVOL, A MORE HOLISTIC MEASURE OF IMPLIED VOLATILITY
In the Black-Scholes model, implied volatility is the only variable that isn’t directly observable in the market. The underlying price, strike price, risk-free interest rate and time to expiration are known, but the future volatility of the underlying is not and this is essential for options pricing and why it deserves so much attention.
Chart 1: CBOT Corn Dec24 volatility curve below, giving a nice graphical view of the volatility smile.
Traditionally, when assessing perceived forward volatility,one would go to the options markets and look for the at-the-money strike to assess the implied volatility. Benchmark this against the realised volatility and you’ll get a good indication of the markets perceptions of forward volatility relative to the how things have performed.
Implied volatility at the money is almost never the same across all strikes, it tends to be lowest near at- the-money options and with positive convexity (a nice big smile) you would expect to see the out of the money strikes with higher implied volatilities. Convexity in options refers to how the value of the option changes in a non- linear fashion relative to the changes in the underlying, the options price doesn’t move in a straight line.
Source: Quikstrike
IMPLIED VOLATILITY AT THE MONEY IS ALMOST NEVER THE SAME ACROSS ALL STRIKES, IT TENDS TO BE LOWEST NEAR AT-THE-MONEY OPTIONS AND WITH POSITIVE CONVEXITY (A NICE BIG SMILE) YOU WOULD EXPECT TO SEE THE OUT OF THE MONEY STRIKES WITH HIGHER IMPLIED VOLATILITIES.
We may also see implied volatility skewed to one side, if the market has a particular view or is willing to pay more for protection in a specific direction, we may see a volatility smirk. Skew can indicate the likelihood potential large directional moves, it also hints at smaller moves in the opposite direction.
This considered, the reference to at- the-money implied volatility doesn’t take into account the entire picture, and this is something the CME’s CVOL index tries to resolve.
16 | ADMISI - The Ghost In The Machine | Q4 Edition 2024
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