The volatility risk premium in the oil market

Abstract

This article provides a comprehensive analysis of the volatility risk premium (VRP) in the oil market. We approach the problem from the practitioner’s perspective as an investment strategy that sells and delta-hedges oil options, paying particular attention to the strategy’s risk-adjusted returns and its drawdown characteristics. The results are differentiated across options with different moneyness and expirations and presented in the form of VRP smile and VRP term structure. Strategy results are analyzed using alternative delta-hedging techniques that vary hedging frequencies, hedging thresholds, and volatilities used to calculate options’ delta. We discuss the performance under different regimes and highlight the structural break driven by the changing behavior among main participants in the oil options market.

KEYWORDS:

• Volatility
• Options
• Derivatives
• Commodities
• Oil
• Systematic Trading
• Risk Premium

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1 The first energy volatility swap was originated by the energy trader, Koch Industries, in a deal with the hedge fund, Centaurus, with its details described in Ockenden (2003).

2 WTI futures expire on the 3rd business day prior to 25th calendar day of the month. If the latter is a non-business day, futures expire 3 days prior to the last business day preceding the 25th calendar day. WTI options expire 3 days before the expiration of the corresponding futures contract.

3 See, for example, Gatheral (2006) and Derman and Miller (2016).

4 Each futures and option contract is for 1000 barrels.

5 We should emphasize that in the case of selling options, the return on the option premium is different from the return on cash investment. To calculate the latter, one must also incorporate the cost of the initial margin. This would be a rather difficult exercise as margin requirements are often adjusted by exchanges and clearing houses depending on prevalent volatilities and trade correlation with the rest of the traders’ portfolio. Such analysis will inevitably include trader-specific cost of funding which is outside the scope of this article. Retaining the simple definition of investment returns from the long position, which is equivalent to the percentage of premium retained for the short position, allows us to directly compare our results to other studies.

6 Our definition of return on risk is the same as the information ratio with zero performance benchmark, or the Sharpe Ratio with zero risk-free interest rate, but both the numerator and the denominator in our case are computed in dollars, not in percent. Since we don’t include the cost of capital and exchange margin in our calculations, we don’t include any interest that could be received on such initial margin either. Overall, the impact of financing on the performance of VRP strategy is relatively minor.

7 See, for example, Bouchouev (2020).