Risk Latte - Inverse Leverage Effect in Commodities

Inverse Leverage Effect in Commodities

Team Latte, and
Lynn Raebsamen, Bloomberg

Even though commodities in general behave differently than equities sometimes a few commodities may display behavior similar to the equities, such as what we see in crude oil today. This can confound a market observer. The notion of “inverse leverage effect” in commodities market is quite interesting. This notion has to do with the shape of the implied volatility smile observed in the markets.

Most of us have heard of the "Leverage Effect": When stock prices drop, panic kicks into the markets and implied volatilities rise. For stocks and stock indices, most of the time, we observe that the implied volatility smile is skewed to the left, meaning lower strikes have higher implied volatility. This is understandable because traders, fearful of markets crashing, would price out of the money puts with higher implied volatility than the ATM puts. As the market drops the traders start to mark up the implied vols of the out of the money puts even more and this action feeds on itself. Another way of looking at this is that because investors are always fearful of equity markets crashing they hedge their position with out of the money put options. As the equity market drops, more and more investors run for cover and buy more put options to hedge their long equity positions which in turn increase the demand for puts, especially out of the money puts. Hence, the increased demand for out of the money puts gives rise to higher implied volatility for lower strikes. There is a marked aversion on the part of the traders and investors for markets going down.

In many commodities this effect is reversed. Here, an "Inverse Leverage Effect" can be observed, that is, implied volatilities rise when commodity prices increase.This means that higher strikes display higher implied volatilities. The volatility smile derived from the options is skewed to the right, implying aversion in the market to a rise in commodity prices.

The explanation is simple: When commodity prices go up, it is generally bad for the economy, so that is when panic sets in and volatilities rise.

However, in the last 5 years, an interesting fact can be observed. The inverse leverage effect can still be clearly detected with agricultural commodities such as Soybeans (slide 1). However, it doesn't hold true for Crude Oil (slide 2). Why?Here's a possible explanation: the absence of inverse leverage effect in crude oil is because these days more investors have long interest in Crude Oil than physical hedgers.Panic breaks out when Crude prices drop, thus pushing implied volatility levels up. The same goes for other heavily traded commodities more for investment rather than physical hedging purposes, such as Copper.

Slide #1: Inverse leverage effect in agricultural commodities, like soybeans.

The above Bloomberg slide(slide #1) shows price of soybeans versus its 3M implied volatility and the percentage correlation between the two. It is clearly showing Inverse Leverage Effect most of the time, i.e. when soybean prices go up, volatility rises, because panic over food inflation breaks out. The same can be observed for other agricultural commodities, like wheat and corn.

Slide #2: Inverse leverage effect is not visible in Oil

The above Bloomberg slide(slide #2) shows the price of WTI crude oil versus its 3M implied volatility and the percentage correlation between the two. The behavior here is much more like the equity markets. When crude prices drop, volatility rises. It doesn't reflect the inverse leverage effect, and we assume it is because these days many investors have open interest in crude than physical hedgers and therefore panic breaks out when crude prices drop, thus pushing implied volatility levels up. The same can be observed with some base metals, as well, such as copper.

Reference: We are grateful to Lynn Raebsamen from Bloomberg, Hong Kong for providing us with the relevant charts.

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