A Crazy Day in Oil
It seems that every few years investors are forced to learn about the Straits of Hormuz. Oil traders have always been familiar with its constraints but now details of its geography and strategic importance are front page news. By now, I’m sure you now know more than you ever thought you would about it (or wanted to!).
The effect of the Strait’s closure has been well-documented elsewhere, although mostly in apocalyptic terms. By my informal assessment, doomscrolling reached its peak over the weekend with social media and the MSM unanimously predicting an oil price shock that would bring the global economy to its knees. It is therefore not surprising that crude (WTI) blew through $100 almost immediately on Sunday night and peaked out at $118.81, almost 31% higher than it’s close last Friday. It reminded me more of a meme stock than an internationally traded, highly liquid commodity.
I probably don’t need to remind you of what ultimately happened, but it was something that very few would have anticipated on Sunday night. Almost everyone was so fixated on the Straits that they neglected to account for the possibility that petroleum reserves might be tapped or that the war might not last as long as commonly believed. The result was a two-phased plunge that left crude oil down for the day with a $38.29 high/low range, or 40% of Monday’s settlement. Imagine if the S&P swung 2700 points in a single day and you get the idea.
As you can see below, implied volatility acted accordingly. Since the beginning of the war, crude oil’s 30-day implied volatility (P/C average) is up about 52 points, from 62% to 112%.
Source: OptionMetrics
However, although crude oil options are susceptible to trading over 100% implied volatility, it is relatively rare and traders tend to think that it more common than it actually is. Since 2005, there have only been 42 trading days in which it has traded over 100%, and 21 one of them occurred during April 2020 when prices went negative briefly (now that was a crazy day!).
One interesting aspect of crude oil that is similar to that of many stocks and instructive is that the correlation between its daily return and changes in implied volatility tends to be negative. Although this is mostly true, extreme price shocks can sometimes break the negative relationship, as has been evident in oil since the war began. Implied volatility is related to uncertainty, and as the duration and outcome of the war becomes more or less evident, it will change. Hence, if oil continues to fall, implied volatility will decrease, and vice versa if oil starts to spike again. But, if oil begins to plunge precipitously, then the standard negative relationship between oil and volatility will resume and crude oil’s implied volatility will start increasing again. Again, it’s all a matter of uncertainty.
Source: OptionMetrics