Introduction Theory Data Results Conclusion Option Returns, Risk Premiums, and Demand Pressure in Energy Markets Kris Jacobs University of Houston Bingxin Li West Virginia University August 17, 2021 OptionReturns,RiskPremiums,andDemandPressureinEnergyMarkets:JacobsandLi 1/22 Introduction Theory Data Results Conclusion Background Energy markets Increasing importance in financial markets Account for more than 70% of the S&P GSCI as of dollar weight Energy options are widely used in financial risk management A large literature in index and equity option returns; however, relatively few studies on energy option returns and risk premia Christoffersen and Pan (2019) Dew-Becker, Giglio, and Kelly (2019) Kang and Pan (2019) Prokopczuk, Symeonidis, and Simen (2017) OptionReturns,RiskPremiums,andDemandPressureinEnergyMarkets:JacobsandLi 1/22 Introduction Theory Data Results Conclusion Objectives Understand energy option returns as functions of maturity and moneyness, and across markets Returns on energy option strategies Delta-neutral portfolio, straddle, and zero-beta straddle Interpret these findings from the perspective of the existing theories, as well as the empirical results on index and equity option returns the variance risk premium the option traders’demand pressure OptionReturns,RiskPremiums,andDemandPressureinEnergyMarkets:JacobsandLi 2/22 Introduction Theory Data Results Conclusion Theory Coval and Shumway (2001, JF) Expected returns on calls are positive (higher than the risk-free rate) Expected returns on puts are negative (lower than the risk-free rate) Expected returns are increasing as a function of moneyness (K/F) These testable hypotheses are obtained for index option returns, assuming a "classical" pricing kernel that is monotonically decreasing in wealth OptionReturns,RiskPremiums,andDemandPressureinEnergyMarkets:JacobsandLi 3/22 Introduction Theory Data Results Conclusion Theory Bakshi and Kapadia (2003, RFS) Delta-hedged gains are zero in a Black-Scholes economy (with continuous rebalancing) With stochastic volatility, delta-hedged gains reflect the sign of the variance risk premium (the priced variance risk) These testable implications are for index option returns OptionReturns,RiskPremiums,andDemandPressureinEnergyMarkets:JacobsandLi 4/22 Introduction Theory Data Results Conclusion Alternative Determinants of Return Patterns Within a neoclassical framework: variance-dependent pricing kernels See Bakshi, Madan, and Panayotov (2010, JFE) and Christoffersen, Heston, and Jacobs (2013, RFS) Some success in explaining patterns in index option returns (Broadie, Chernov, and Johannes, 2009; Bondarenko, 2014) and crude oil options (Christoffersen and Pan, 2019) Demand-based option pricing See Bollen and Whaley (2004, JF), Gârleanu, Pedersen, Poteshman (2009, RFS) Net demand for different options by end-users puts pressure on prices In commodity (energy) markets, this comes down to hedging demand OptionReturns,RiskPremiums,andDemandPressureinEnergyMarkets:JacobsandLi 5/22 Introduction Theory Data Results Conclusion Data Four CME Energy Derivatives WTI crude oil futures and options (1990-2016) Henry Hub natural gas futures and options (1992-2016) Heating oil futures and options (1990-2016) RBOB gasoline futures and options (2004-2016) Maturities within a year: 1m, 2m, ..., 1y log(K /F ) Nine adjusted moneyness ( p ) intervals, [-2, 2], for each maturity OptionReturns,RiskPremiums,andDemandPressureinEnergyMarkets:JacobsandLi 6/22 Introduction Theory Data Results Conclusion Futures Prices Level (1m) Slope (1m • 1y) ) 150 20 l e r r a 10 B / 100 $ ( 0 l i O 50 •10 e d u r •20 C 0 90 95 00 05 10 15 90 95 00 05 10 15 ) u 5 t 15 B m M / 10 $ ( 0 s a G 5 l a r u t a 0 •5 N 95 00 05 10 15 95 00 05 10 15 The natural gas market was in contango most of the time. OptionReturns,RiskPremiums,andDemandPressureinEnergyMarkets:JacobsandLi 7/22 Introduction Theory Data Results Conclusion Implied Volatility of Futures Options OTM Puts and Calls 0.8 0.8 s l a i 0.6 0.6 G O l e a r d u u t r 0.4 a 0.4 C N 0.2 0.2 0.85 0.9 0.95 1 1.05 1.1 0.85 0.9 0.95 1 1.05 1.1 0.8 0.8 1 Week l i e 1Month O 0.6 0.6 n i l g 3Month o n i s t a 6Month a e 0.4 G 0.4 H 0.2 0.2 0.85 0.9 0.95 1 1.05 1.1 0.85 0.9 0.95 1 1.05 1.1 Moneyness Implied volatilities with shorter maturities are higher in all four markets for all moneyness. Implied volatilities in the natural gas market are higher than the other three markets. OptionReturns,RiskPremiums,andDemandPressureinEnergyMarkets:JacobsandLi 8/22 Introduction Theory Data Results Conclusion Option Returns on Futures Hold-to-maturity returns on futures options call R = max(FT K, 0)/Ct,T 1, t,T put R = max(K FT , 0)/Pt,T 1, t,T where FT is the futures price at maturity T ; K is the strike price; Ct,T (Pt,T ) is the call (put) option price at time t with maturity. OptionReturns,RiskPremiums,andDemandPressureinEnergyMarkets:JacobsandLi 9/22 Introduction Theory Data Results Conclusion Option Returns by Moneyness (1M) Calls Puts ATM OTM OTM ATM [0, 0.2] (0.2, 0.65] (0.65, 1.1] (1.1, 1.55] (1.55, 2.0] Mean [•2.0, •1.55)[•1.55, •1.1)[•1.1, •0.65)[•0.65, •0.2) [•0.2, 0] Mean Panel A. Crude Oil •0.07 •0.14 •0.33 •0.56 •0.89 •0.47 •0.57 •0.36 •0.14 •0.01 0.01 •0.26 (0.89) (•1.69) (•3.21) (•4.92) (•13.68) (•7.90) (•2.51) (•2.13) (•1.02) (•0.10) (0.13) (•2.86) Panel B. Natural Gas 0.03 •0.11 •0.14 •0.52 •0.61 •0.26 •0.26 0.10 0.15 0.15 0.18 0.10 (0.21) (•0.84) (•0.85) (•3.16) (•2.39) (•2.68) (•0.88) (0.39) (1.05) (1.44) (1.87) (1.00) Panel C. Heating Oil 0.09 •0.06 •0.38 •0.70 •• •0.18 •• •0.61 •0.23 •0.16 •0.08 •0.19 (0.75) (•0.59) (•3.03) (•4.58) •• (•2.15) •• (•3.30) (•1.15) (•1.20) (•0.69) (•1.85) Panel D. Gasoline 0.10 •0.01 •0.47 •0.61 •• •0.22 •• •0.54 •0.19 •0.09 0.00 •0.17 (0.65) (•0.10) (•3.36) (•2.75) •• (•1.99) •• (•1.85) (•0.64) (•0.48) (•0.02) (•1.04) Returns on OTM calls and puts are on average negative, except for natural gas put options. OTM call returns are lower (more negative) than put returns. Call (put) option returns in these three markets decrease (increase) in strike price. OptionReturns,RiskPremiums,andDemandPressureinEnergyMarkets: JacobsandLi 10/22 Introduction Theory Data Results Conclusion Option Returns by Maturity Crude Oil Natural Gas Heating Oil Gasoline Maturity Calls Puts Calls Puts Calls Puts Calls Puts 1m •0.47 •0.26 •0.26 0.10 •0.18 •0.19 •0.22 •0.17 (•7.90) (•2.86) (•2.68) (1.00) (•2.15) (•1.85) (•1.99) (•1.04) 2m •0.19 0.05 0.05 0.09 •0.09 •0.09 •0.12 •0.01 (•4.21) (0.83) (0.76) (1.75) (•2.16) (•1.30) (•2.05) (•0.08) 6m 0.04 0.16 0.03 0.03 0.03 0.09 0.01 0.10 (1.67) (3.50) (1.12) (1.06) (1.08) (1.44) (0.22) (0.80) 10m 0.06 0.08 0.01 0.07 0.04 •0.04 •• •• (2.54) (2.72) (0.32) (2.38) (1.21) (•1.53) •• •• Mean •0.22 •0.02 •0.07 0.08 •0.10 •0.09 •0.14 •0.07 (•10.81) (•0.71) (•2.08) (2.59) (•3.41) (•2.39) (•3.30) (•0.96) Average short-maturity option returns are negative (except for the natural gas put options). Option returns increase in maturity and become positive at long maturities. OptionReturns,RiskPremiums,andDemandPressureinEnergyMarkets: JacobsandLi 11/22 Introduction Theory Data Results Conclusion Average Option Returns (Crude Oil) Crude Oil Calls Crude Oil Puts 0.5 0.5 0 0 1 Month •0.5 •0.5 •1 •1 •2 •1 0 1 2 •2 •1 0 1 2 2.5 2.5 90•16 2 2 90•04 05•08 1.5 1.5 09•16 1 1 6 Months 0.5 0.5 0 0 •2 •1 0 1 2 •2 •1 0 1 2 Adjusted Moneyness Call (put) returns in a booming market is higher (lower). Average short-maturity (long-maturity) call returns decrease (increase) in strike price. Average put return patterns are opposite to call returns. OptionReturns,RiskPremiums,andDemandPressureinEnergyMarkets: JacobsandLi 12/22 Introduction Theory Data Results Conclusion Findings in Energy Option Returns Returns on OTM short-maturity options are negative, except for natural gas put options Average call returns are lower (more negative) than put returns at short maturities Short maturity put option returns increase with moneyness (K/F), while short maturity call option returns decrease with moneyness Option returns increase as a function of maturity, except for natural gas put options Average return patterns on natural gas market are different from the other three markets OptionReturns,RiskPremiums,andDemandPressureinEnergyMarkets: JacobsandLi 13/22 Introduction Theory Data Results Conclusion Evidence from Other Option Markets Index option returns show that average call returns exceed average put returns. Index option presents very large negative returns on OTM puts. That call (put) option returns decrease (increase) with strike prices is consitent with our findings (Broadie, Chernov, and Johannes, 2009; Bakshi, Madan, and Panyotov, 2010; etc.). U-shaped pricing kernels = moneyness pattern. ) OptionReturns,RiskPremiums,andDemandPressureinEnergyMarkets: JacobsandLi 14/22 Introduction Theory Data Results Conclusion Delta-Hedged Returns Following Bakshi and Kapadia (2003, RFS), the daily-rebalanced delta-hedged option gain for a call option over a period [t, T ] is c c t, T = max(FT K, 0) Ct, T t+n 1, T (Ft+n, T Ft+n 1, T ) n=1 X c rf (Ct, T t+n 1, T Ft+n 1, T ).