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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? March

October

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  • $\begingroup$ quant.stackexchange.com/questions/4936/…, and the fact that an option price is not only a function of implied volatility. $\endgroup$ – Matt Feb 25 '15 at 7:56
  • $\begingroup$ Thanks. For a far OTM option, is it fair to say that the price is only a function of volatility, since all greeks except vega will be very minimal? $\endgroup$ – Victor123 Feb 25 '15 at 16:41
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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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