Reading an Inverted Implied Volatility Term Structure
Summary
The document explains why a farther-dated option can show lower implied volatility than a near-term option while still having a higher premium. It describes an inverted volatility term structure: near-term implied volatility is elevated, while the market expects volatility to ease over the longer horizon. In the example, the near-term option has 54% implied volatility and the later option has 43%, despite the later option costing more.
The key interpretation is that longer-dated implied volatility summarizes expected volatility across the period to expiration, rather than simply measuring uncertainty at the expiration date. The later estimate therefore incorporates the volatile near-term period alongside the subsequent months. Option premiums also depend on time to expiration, so a higher premium does not by itself imply a higher implied volatility. The example refers to USO during a steep correction and geopolitical tension; the term structure reflects market expectations and can change over time. The document offers a qualitative explanation, not a general forecast or pricing formula.
Key ideas
- An inverted volatility term structure has lower implied volatility for farther expirations than for nearer ones.
- Longer-dated implied volatility reflects expectations across the full period to expiration.
- A longer-dated option can cost more because it has more time remaining, even when its implied volatility is lower.
- The term structure reflects current market expectations and can change over time.
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Full text
# Why implied volatility is less for the back month option even though the back month option is more expensive # Why implied volatility is less for the back month option even though the back month option is more expensive Why is the implied volatility of this option at the ATM strike (18$) greater in the front month (March) than in a further month (Oct). The Oct month has 43%, but the front month has 54%. Should not the volatility be more in the back month since it is further, hence more uncertain, hence there is greater possibility of a large move. And if the back month has a lesser IV, how come the back month option has a more expensive premium(2.52) as opposed to March (1.05)? Higher premium should be due to higher IV, correct? ## Answer by S Patton (score 0, accepted) https://quant.stackexchange.com/a/16748 Your question concerns the term structure of volatilty. In this case, USO's vol term structure is inverted (downward sloping) since far-dated IV is less than current. Please keep in mind that the market determines the shape of the term structure and it can and will change over time. Currently, USO has seen a steep correction and there is some geopolitical 'sabre rattling' leading to high realized vol and also high implied vol; but the market thinks this volatility will subdue over time. Hence the inverted term structure of vol. As for your comment "Should not the volatility be more in the back month since it is further, hence more uncertain, hence there is greater possibility of a large move?" don't think of it this way. Your intuition is that it's easier to "predict" March 20 price than the Oct 16 price, so therefor the Oct 16 contract is more uncertain and should have higher IV. This is not the correct way to think of this. Rather, think of the IV in the Oct 16 contract as an average IV over the next six months. So infact the 43% Oct IV includes the 54% March IV, implying that market participants think USO will be very volatile in the near-term but will subdue substantially in the subsequent five months.
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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.