There are two commonly referenced measures of market price uncertainty: historical volatility and implied volatility. Historical volatility measures how much prices have varied in the past, and implied volatility uses options prices to measure how market participants believe prices will vary in the future. In the Brent crude oil market, implied volatility is currently higher than historical volatility because of continuing market uncertainties (Figure 1). Implied volatility is expected to remain high until these uncertainties are resolved.
Historical volatility is calculated from the daily price movements of the front month futures price, typically for a 30-day period. It provides a snapshot of the magnitude of recent up-and-down price movements, but by definition is a backwards-looking metric.
Implied volatility is calculated from the prices of call and put options traded on futures contracts. The Black-Scholes option pricing model is widely used to price crude oil futures options based on a number of factors: the current trading price of the crude oil futures contract; the strike price of the option contract; the time until the option contract expires; and the expected future volatility of the price of the underlying crude oil futures contract. The only one of these variables that is not immediately observable is expected future volatility. By using the Black-Scholes option pricing model and the known values of the crude oil futures contract, the strike price of the option, the time until the option expires and the current trading price of the option contract, it is possible to calculate the future volatility that is implied by the relationship of the known values, hence "implied volatility."
Historical and implied volatility can diverge when expectations about future price movements differ from recently observed price trends. Historical volatility increased in late June and early July reflecting the rapid drop in crude prices before July 1 and the rapid increase after July 1. Since that time, Brent futures prices have traded in a relatively narrow range, because there have been few significant surprises in crude oil markets over the past month, and historical volatility has reverted to its level over the March-through-May period. Implied volatility did not spike along with historical volatility, implying that market participants did not change their view of longer-term risks, despite the short-term price changes. As the sudden price changes during the middle of the year dropped out of the historical volatility calculation, the two volatility measures returned to their earlier relationship.