Editor’s Note: The post has been updated to include an additional graphic (Figure 3), illustrating margins vs. volatility in crude oil trading, April 14 to May 16, 2011.

Volatility is a rather abstract concept, but for several reasons, it is also a fundamental ingredient in the functioning of a derivatives marketplace. Commercial interests only have a need to manage or hedge risks when a market is volatile. Likewise, speculators are only afforded profit opportunities when the markets are volatile.

Volatility is also a word that can trigger emotional responses in people, so let’s take a step back from any subjective aspect and briefly explore some of the facts behind the word.

A market may be volatile whether it is moving up or down or even when it is in a sideways holding pattern, provided there is a “large” amount of price movement. And the market may exhibit little volatility when it is trending upward or downward if the movement is sufficiently slow. So in this regard, volatility does not necessarily refer to a bullish or a bearish market trend. Rather, it is a reference to price movement in the absolute.

In other words, it is not a measure of directional performance, but is often used as a measure of financial risk. Assets which exhibit high volatility, such as emerging market equities, typically are considered to be more risky than assets with a lower volatility such as short-dated, low credit risk government bonds.

There are many ways in which to measure market volatility. Most frequently, it is quoted as the standard deviation of day-to-day price movements on an annualized basis. For example, you may see the S&P 500 Volatility Index (VIX) quoted as 15 percent, 20 percent, 25 percent, and so on.

Analysts generally assume that market movements or volatility conform to the familiar “bell-shaped” or “normal probability” curve. Thus, statistically speaking, a volatility of 20 percent would imply there is a roughly two-thirds probability that, at the conclusion of one year, the market price will be within a range of 20 percent above or below the current market price. Or, that there is a roughly 95 percent probability that, at the conclusion of one year, the market price will be within a range of two standard deviations or 40 percent above or below the current market price. Or, that there is a roughly 99 percent probability that, at the conclusion of one year, the market price will be within a range of three standard deviations or 60 percent above or below the current market price.

CME Clearing is responsible for establishing performance bond, or “margin,” levels in CME Group products. Margins are generally established at levels that reflect market volatility and provide for a high degree of certainty that the margin will cover a maximum expected one-day close-to-close price movement. Accordingly, CME Clearing monitors characteristic levels of volatility in all CME Group markets very closely and will act quickly to adjust margin levels in response to changes in volatility. In setting margins, three different kinds of volatility are examined:

• Historical volatility – price changes from one day’s close to another;
• Intraday volatility – price changes within a market session, regardless of whether there are price changes from close to close; and
• Implied volatility – forward-looking measure of potential volatility, derived from analysis in the options markets.

Figure 1 below illustrates margins vs. volatility in silver trading for April 14 to May 16, 2011. You can see that CME Clearing raised margins when market volatility exceeded existing margin levels. Figure 2 shows a similar graph for gold trading over the same period. In this case, there was no reason to adjust margins, as all the historical volatility was covered by the existing margin levels. Similarly, Figure 3  shows margins vs. volatility in crude oil.

(Orange bars represent daily volatility, while the gray represents margin levels.)

Figure 1

Figure 2

Figure 3

Leverage, or the ability to control significant resources with a relatively small investment, is one of the primary advantages of trading futures. That said, CME Clearing conducts thorough and objective analysis and is responsible for maintaining margins at levels that will ensure the financial integrity of each and every transaction on CME Group exchanges. CME Clearing takes this responsibility very seriously because, above all else, it is critical to maintain the ongoing financial viability of exchange operations.

The World Economic Forum indicated in a recent report that the ever more interconnected global economy is most likely a major contributor to increased volatility.

As my colleague Kim Taylor has stated, CME Clearing is a neutral participant in financial markets. It is the organization’s goal to protect the market – whichever way it moves.

Click for information related to CME Group’s Crude Oil Volatility Index futures and Gold Volatility Index futures and options on futures.

John Labuszewski is managing director of research & product development at CME Group.