Crude Oil Options: Volatility Skew

Implied volatility of out-of-the-money put options on Crude oil is higher than the implied volatility of comparable calls. In fact, the gap between the two is at a 5-year high according to Bank of America Securities-Merrill Lynch, quoted Monday on Bloomberg. That is, for the moment, put prices, and volatility, are skewed much higher than call prices. The indicator appears to be very similar to the CSFB Fear Index that measures skew in stock index options.

Here’s the question I have: what does a record-setting skew mean going forward for prices? Is the fact that puts are much more expensive a contrarian signal? That is, are the expensive puts a bullish sign? Or is the fact that option buyers are willing to pay a relatively higher price for puts than they are for calls a sign that the market is poised for a fall?

Unfortunately, we can’t tell from the raw data itself. While I have one of the world’s largest databases of stock and index option information, I don’t have the same depth in the commodity options. So I have to rely on some other method. Fortunately, Bloomberg does a very nice job of providing some pretty incredible charts. One of the charts in the article shows the spread between the implied volatilities of crude oil options (pink line) — the skew.

Click image to enlarge

The problem with this particular chart is that it doesn’t show the skew with the actual price of crude for comparison, so here’s what I did. I screen-captured the Bloomberg chart of the implied volatility spread (skew), enlarged it, and then superimposed that chart onto a similarly scaled chart of the front-month crude oil futures price over the same time frame. Although we don’t have precise data with which to do a statistical analysis, we can “eyeball” the indicator to see if this skew is predictive of any kind of movement.

Click on the link below to download the chart: Crude Oil Vs Oil Fear Index

As you can see from the chart, the skew recently peaked at a new 5-year high reached just a few weeks ago. In the price chart above, the indicator is a graph of crude oil (black line). The red line in that top chart measures all moves that exceeded 15% (accomplished using MetaStock’s ZigZag indicator). That allows us to easily visualize any substantial move in crude oil prices.

According to these charts, there doesn’t seem to be any evidence that a spike in the volatility skew leads to a subsequent decline in crude oil prices. In fact, you could make the case that a peak in the skew precedes or coincides with significant rallies.

You can download the pdf file and mark it up yourself. If you find anything worthwhile, feel free to post a comment.