Why is Implied Volatility Important to Commodity Hedging

If you have been tempted to purchase an option in the past but are unsure how it is valued, you need to understand a critical concept. The price of options contracts is calculated using several criteria. The most important concept to understand is that the value of an options contract is based on the likelihood that the underlying price of the commodity is above or below a specific level by the time the option contract expires.

What is an Option and What Drives the Value

Several criteria are used to derive the value of an option contract. The current price of an underlying commodity plays a significant role in the strike price. The strike price is the price you have the right to buy or sell the underlying asset. A call option is the right to buy commodities, and a put is the right to sell if you are engaged in commodity hedging.

The most critical input determining the premium of an option for commodity price risk is implied volatility. Implied volatility is a market input decided by traders and other market participants. Implied volatility describes the future change in the price of a commodity.

Implied volatility differs from historical volatility, which is how much the market has moved. The percent calculation is determined by a statistical term called standard deviation. When you multiply the standard deviations of the returns of a commodity by the square root of time, you create historical volatility.

How Do You Trade Using Implied Volatility?

When you ponder the role of implied volatility in option valuation, think about this. The higher the implied volatility, the better the chance that an option will be in the money at expiration. As the chance of the option settling in the money rises, the premium of an option will climb. Additionally, higher levels of implied volatility will usually reflect a more robust demand for commodity hedging.

The chart of the implied volatility-mean of SOYB (the Teucrium Soybean ETF) shows that soybean volatility has climbed and accelerated as Russia attached Ukraine. Traders looking to buy options should look for periods when implied volatility is low. Traders considering selling options should look to do so when implied volatility is elevated. During the past 5-years, the implied-volatility range has been well defined, allowing commodity risk managers a clear range of when to purchase protection and avoid buying options.