Does market volatility matter?

Bean prices bounced off the recent trading lows this week. While this was positive for farmers, there still remain several unknowns. Dry weather throughout the Midwest has many in the trade concerned and wondering what summer time weather will be like and if yields will suffer. Also, it’s uncertain how many acres farmers will plant this spring. This may ultimately mean some speculators will exit their short positions with some profit now and look for other opportunities down the road.

With farmers generally not selling, basis and short-term corn spreads have narrowed throughout the Midwest until late this week. Then the corn market moved to the top of a narrow 10-cent trading range, which encouraged some farmers to sell some of their grain. I expect small fluctuations like this to continue in the short-term but I’m not expecting there will be a big rally unless something catches the market completely off guard. It’s still a long time until summer weather markets can affect these markets.

 

Why I don’t care about volatility values

Recently some advisors and experts have been talking again about the importance of volatility in the option market and that farmers should consider it within their marketing strategy. They explain that “because volatility is the lowest it’s been in 10 years that it’s not a good time to sell options and instead farmers should be buying them.”

I usually find that these “experts” are always looking for reasons to recommend buying options. Generally, I think buying options is usually the least advantageous avenue for farmers and their rationale of “market volatility” doesn’t change my mind. Unfortunately, when these experts describe market volatility’s impact, it can easily get complicated, which can mislead farmers into thinking volatility is more important than it actually is to a farmer’s marketing strategy.

 

What is market volatility?

For grain markets, volatility is basically the expectation of the upcoming pricing movement of the market. For example, if there are many unknowns, like in the summer when it’s unclear when and how much it will rain throughout the Midwest, there is significant price movement potential (i.e. volatility) up or down. On the flip side, during harvest there is typically lower volatility because there are fewer unknown issues that can impact price movement.

Higher volatility will generally mean options have higher values relative to future prices. Lower volatility would mean options values should be lower compared to futures prices.

There are several factors that affect the value of volatility on options including the time left before the option expires, actual value of the option and the amount of market unknowns. Normally option volatility is measured by standard deviation, which is stated as a percent of value.

Yes, it’s extremely complicated. To put it into very simple terms, 12% volatility is widely seen as being extremely low, whereas anything over 30% is considered very high. In 2011 and 2012 volatility levels exceeded 30%. From 2013 to 2015 volatility ranged between 18% and 25%. Over the last six to 12 months, volatility has been under 15%, and in January it went below 10%.

 

Why market volatility can be misleading

Usually when “advisors” discuss low volatility they seem to only reference short-term values, which doesn’t provide a complete picture. A very near-term option may have low volatility today, but an option with a longer time value left will have higher volatility because of more potential price movement from market unknowns. For instance, as short-term option’s volatility fell below 10% on the Feb options, the July option volatility was trading over 15% and Dec was almost 17%. In general, what we have been seeing with volatility has been that it usually decreases as time narrows.

 

How the importance of volatility can be overblown

Once again the difference between the goals of farmers and speculators has an impact on the importance of volatility. For example, let’s say an option has six months of time left and it moves 2 cents in value. That 2-cent movement could probably shift the volatility by 4% points, which may mean a shift from a low to mid-range level. A farmer wouldn’t generally be any more motivated to buy or sell an option from just a 2-cent movement in the value of an option because they’re usually trading less than 10 options at a time. Speculators and fund traders on the other hand are trading hundreds or thousands of options at a time. With that many options, 2 cents makes a big difference on their bottom line, hence market volatility is a bigger factor to them.

 

What can we learn from market volatility?

Market volatility is a great measure of what traders are expecting from the market over time. Low volatility essentially means that most market participants think the market is going nowhere. High volatility means there is more uncertainty and potentially more price movement possibilities.

These loose guidelines can be helpful in planning and making decisions in market strategy. Just because there is low volatility doesn’t mean that high volatility or higher prices are just around the corner. Price could continue to be stuck in an extremely tight trading range for another year.

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