|
Dr. Ken Rietz This is the monthly spreads commentary on commodity futures. This time we talk about a potential problem that needs to be addressed in some commodity spreads: volatility, specifically implied volatility (IV). I will give a brief description of IV and how it affects options and futures prices, the types of spreads that are most and least vulnerable to IV and give examples of how to benefit from them and how to identify when spreads are in danger. IV is not as scary as many people make it. There is a scary part, but it stays out of sight, called the Black (a modification of the Black-Scholes equation, to include carry) model. This is indeed a highly complicated equation that can predict prices for options or futures using a collection of input values, including the volatility of the underlying. The problem is that the predicted value of the option is usually quite close to the actual value, but rarely agrees exactly. To make the predicted value match the market’s value, the actual volatility is tweaked a bit, and the tweaked value of the volatility is then called the Implied Volatility (IV – as in, the volatility implied by the equation). It is reasonable to view IV as the market’s expectation for the volatility of the commodity. The value of IV has a direct impact on the price of the option, and the relationship is simple: The higher the IV, the higher the price of the option. That means that when the price of the underlying commodity spikes, the IV also increases significantly, amplifying the effect on the associated futures. And with that, we can begin to investigate the effect of IV on spreads. When the IV is relatively equal on both sides of the spread, its effect is invisible. That means that for vertical spreads, IV is not noticeable. Nor is it going to affect product spreads much, since any change in IV will propagate into the products. The real problem can occur with intermarket spreads, since there are two commodities that can be affected differently by their own IVs. Let’s look at examples. Let’s consider the corn-soybean intermarket spread, one of the most common, and you are an investor rather than a hedger. Suppose you buy 5 ZCU25 (September 2025 corn futures) at 434 each and sell 2 ZSU25 (September 2025 soybean futures) at 1020 each, because you expect corn to do worse than soybeans next year. Doing the calculations gives you a net credit of US$1.30 at the moment. The chart for this is given below. |
 |
|
Figure 1: A corn-soybean Sep 25 spread with CBOT But suppose that a major event affects just the soybean side, such as a serious drought in the relevant parts of South America. The price of soybeans would skyrocket, and the volatility would as well, causing the ZSU25 futures to explode, while the corn futures would hardly budge, since genetically modified corn is remarkably resistant to drought. The spread that you wanted to generate funds goes underwater almost instantly, a most unpleasant situation. But there is the other side of this coin, where you can make money from an increase in volatility. The simplest way to do this is to take advantage of a short-term event that causes a future to spike briefly before settling down. Suppose you take the same setup as in the previous paragraph, but now the corn crop in South America is being attacked by an insect, and the prognosis is not good. But there is also a good chance that the corn is genetically modified to withstand that bug with minimal impact, but that will probably not be known immediately. In that case, the price of corn will go up, as will the volatility of the corn future. This sets up a potentially significant increase in the value of the spread, and an investor would be prudent to close the spread while the price was high, and before the price of the corn future returns to previous values. In general, setting up a big spread either for investing or hedging requires considerable vigilance. Several of the following events have affected the price of grains in general, and the volatilities of futures.
While none of these are liable to happen at any specific time, monitoring these is important so that you are not blindsided by the spread. Spreads are powerful, but the circumstances controlling them are not always reliable. |