Abstract
This chapter looks at writing oil options from the perspective of the insurance product, which is the essence of gamma trading and the resulting volatility risk premium. We dissect the historical performance of various strategy specifications from multiple angles, introduce the concept of the VRP smile, and identify regime breaks caused by changing behavior of large market participants.
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Notes
- 1.
Note that this analysis is presented on the trade level. Since the trades are entered once a month and held for three months, multiple trades are open at the same time. The analysis of the continuously managed strategy of selling options is presented later in this chapter.
- 2.
This point is well covered in Derman and Miller (2016).
- 3.
The existence of the volatility or variance risk premium in oil options has been documented in several studies, see Doran and Ronn (2006, 2008), Trolle and Schwartz (2010), Kang and Pan (2015), Prokopczuk et al. (2017), Ellwanger (2017), and Jacobs and Li (2023). The analysis of VRP as the actual trading strategy, which we present here, is a much more difficult task due to its extreme path-dependency and non-straightforward measurements of risks. The remainder of this chapter is based on empirical results of Bouchouev and Johnson (2022). The author would like to thank Brett Johnson for his highly valuable contribution to the data analysis.
- 4.
The challenges that arise with annualization of risk-adjusted returns are well explained by Lo (2002).
- 5.
As before, we calculate the Sharpe ratio assuming zero risk-free interest rate. Since we do not include the cost of capital and exchange margin in our calculations, we do not include any interest that could be received on the initial margin either. Overall, the impact of financing costs on the performance of VRP strategies is relatively minor. In addition, both the numerator and the denominator of the Sharpe ratio here are computed in dollars per barrel, not in percent.
- 6.
Another popular reduced-hedging strategy is to trade fewer futures than required by the model. The details of this strategy can be found in Bouchouev and Johnson (2022).
References
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Doran, J. S., & Ronn, E. I. (2006). The bias in Black-Scholes/Black implied volatility: An analysis of equity and energy markets. Review of Derivatives Research, 8(3), 177–198.
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Ellwanger, R. (2017). On the tail risk premium in the oil market, Bank of Canada Working Paper, 46.
Jacobs, K., & Li, B. (2023). Option returns, risk premiums, and demand pressure in energy markets. Journal of Banking and Finance, 146, 1–26.
Kang, S. B., & Pan, X. (2015). Commodity variance risk premia and expected futures returns: Evidence from the crude oil market, SSRN.
Lo, A. W. (2002). The statistics of Sharpe ratios. Financial Analysts Journal, 58(4), 36–52.
Prokopczuk, M., Symeonidis, L., & Simen, C. W. (2017). Variance risk in commodity markets. Journal of Banking and Finance, 81, 136–149.
Trolle, A. B., & Schwartz, E. S. (2010, Spring). Variance risk premia in energy commodities. The Journal of Derivatives, 17(3), 15–32.
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Bouchouev, I. (2023). The Hidden Power of Negative Gamma. In: Virtual Barrels. Springer Texts in Business and Economics. Springer, Cham. https://doi.org/10.1007/978-3-031-36151-7_9
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