Our chart of the week examines the relationship between the price of the CME’s flagship Crude Oil contract, WTI (to eliminate the frequent aberrations that can characterise the front month, we look at the second month) and volatility. Volatility can be defined as the speed and severity of price changes and is calculated using standard deviation or variance.

The curious aspect of the relationship between oil prices and volatility is that they are inversely correlated. This reverse relationship is not set in stone, but more often than not, volatility tends to spike when oil prices are pushed over the precipice. The three most glaring examples are the 2008 financial crisis, which sent the price of the U.S. benchmark from $147 to $32 in the space of six months; the emergence of the U.S. shale sector in 2014, which led to a price drop of $60, or 60%; and the demand destruction caused by the COVID-19 pandemic.

There are numerous reasons for this inverse correlation: In a sharp downtrend, producers tend to hedge more aggressively, consumers delay their purchases and, given the financialisation of the futures markets, money managers tend to reallocate funds from oil to other asset classes as margin calls (the cost of trading) usually rise with elevated volatility.

High volatility creates uncertainty and reduces appetite for futures trading. This, however, does not mean that the oil market must be deserted. A high- or extreme-volatility regime offers attractive opportunities to trade options, which give the buyer the right and oblige the seller to transact in the future at a pre-agreed price (the strike price).

Volatility is one of the five factors that affect the price of an option – namely, the premium. The higher the volatility, the more the seller of the option will charge because of heightened unpredictability. Writing options, therefore, appears to be a more reasonable alternative when volatility spikes, whereas purchasing options is more attractive when it is subdued.

Options traders constantly express their views on the speed and severity of price changes in the form of implied volatility. For the second-month WTI contract, it is currently well over 40%, which is at the higher end of the historical range. Thus, for those betting on lower prices, it is more conducive to write call options than to buy put options. Of course, selling an option offers limited gain and unlimited loss should oil prices move against the position. It is, therefore, only prudent to sell in-the-money call options and mitigate the risk by acquiring out-of-the-money call options, collecting the difference between the two premiums while capping the upside risk should oil prices move higher.