Implied Volatility in Agricultural Options

By: Dave Caplan

The following is an excerpt from Dave Caplan's The Option Secret

A trader’s expectation of volatility must dictate his or her strategy, since the flat-price outlook can be traded from either a long or short volatility perspective.  What beginning option traders often fail to realize is that, more often than not, it is the correct volatility perspective that determines the success or failure of options trading, not the correct flat-price outlook.

Intuitively, just as there is seasonality in the level of agricultural prices, there is seasonality in the movement of agricultural prices.  After a three or four month growing period in the United States, crop production will either be abundant or deficient, and prices must adjust accordingly during that short period.  Therefore, weather is the overwhelming determinant of price volatility, though volatility will rise or fall due to other isolated events.  The Chernobyl nuclear accident in the Soviet Union in May 1986 is one example of this type of isolated event.  These phenomena are unpredictable and common to all options markets; however, they are not our concern here.

Agricultural options have been traded during periods of both abundant crops and drought; therefore, options traders effectively have their volatility boundaries defined, as well as a clear picture of the seasonality of volatility.  From this, a partial solution to the long volatility/short volatility quandary is obtained.

Soybean Implied Volatility: Historical Trends

If one disregards the 1988 drought (May – August 1988), the table below demonstrates that soybean option implied volatility has averaged about 20 percent from 1985 – 1988.  Distinct boundaries are recognized above and below this average: 30 percent as the upper boundary and 10 percent as the lower boundary.  Drought scares did occur in 1986 and 1987, but with large stocks in the hands of farmers and the government, large price adjustments were not necessary, and thus volatility had trouble maintaining the 30 percent level.

In the summer of 1988, however, the severity of the drought, combined with an earlier drawdown of stocks, called for radical price adjustments.  Volatility broke through the 30 percent level and reached an average high of 72 percent in July 1988.  In fact, in some strike prices, implied volatility went over 100 percent.

This was because exchange rules allowed nearby futures contracts to trade without limits, and these contracts were subjected to price moves on the order of fifty cents to a dollar (that is, more than three times the normal limits).  In addition, since futures contracts were often ‘locked-limit’ while options continued to trade, traders used the options pit to offset risk or to initiate new trades, which caused volatility to be bid up accordingly.

Corn, Wheat, Soymeal, and Soyoil Implied Volatility

Because the fundamentals of other agricultural commodities were similar to those of soybeans during the period in question (1985 – 1988), they tended to follow the same implied volatility pattern.  Again, ignoring the 1988 drought for the moment, corn option implied volatility has averaged 20 percent; its lower boundary is 10 percent, and its upper boundary reached 35 to 40 percent. 

The 1988 drought caused a breakout above the upper boundary to a high of 75 percent.  The upper boundary for wheat option implied volatility was 30 percent, and its drought breakout reached 60 percent.  Soymeal and soyoil option implied volatility were nearly identical to that of soybeans.

Trading Conclusions

Three important trading implications can be drawn from the situation just described.  First, lower boundaries are similar across commodities and tend to be solid; that is, they represent opportunities to buy volatility.  Specifically, the area between the average and lower boundary (10 to 20 percent) is generally a buying opportunity, especially when implied volatility is expected to increase from a seasonal standpoint.

Second, upper boundaries are usually firm and represent opportunities to sell volatility; again, especially when a seasonal decline is expected.  Finally, when implied volatility breaks out above upper boundaries and stays there, traders should give serious thought to exiting or to adjusting short volatility trades – especially those that have deltas with signs opposite to that of the price move; for example, when the market starts a rapid upward adjustment and a trader is short calls.

At that point, the market should be reanalyzed both fundamentally and technically to establish the significance of the volatility breakout.  As a rule of thumb, however, if such a breakout occurs at the beginning of summer during a short crop year, the bias will be for further movement upward.  If the breakout occurs during any other time of the year – especially in a fundamental background of abundant stocks or sluggish demand – the move should be suspect.

The soybean and corn option trading environment during the 1988 drought is an excellent example of these points.  The tables above show the lows and highs of the different option contracts traded during that period.