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Commodity Option Implied Volatilities and the Expected Futures Returns

Last Updated on 10 February, 2024 by Rejaul Karim

Lin Gao’s paper, “Commodity Option Implied Volatilities and the Expected Futures Returns,” offers an intriguing exploration of the potential forecastability of commodity futures returns through the detrended implied volatility of commodity options (VOL).

The study presents a zero-cost strategy capitalizing on the disparity between low and high VOL commodities, yielding compelling annualized returns of 12.66% and a notable Sharpe ratio of 0.69. Notably, the predictive power of the volatility strategy is primarily observed in its forecasting ability for the future spot component, distinguishing it from other strategies commonly examined in the literature.

Furthermore, this strategy exhibits low correlations with alternative strategies such as momentum or basis, showcasing its resilience, particularly during recessions. Robust results, accounting for illiquidity, commodity pricing factors, and market volatility exposure, underline the efficacy of the VOL measure and its influence on futures and options markets, highlighting the complex interplay of uncertainty, investor preferences, and market dynamics in the realm of commodities trading.

Abstract Of Paper

The detrended implied volatility of commodity options (VOL) forecasts the cross section of the commodity futures returns significantly. A zero-cost strategy that is long in low VOL and short in high VOL commodities yields an annualized return of 12.66% and a Sharpe ratio of 0.69. Notably, the excess returns based on the volatility strategy emanate mainly from its forecasting power for the future spot component, different from the other commodity strategies examined so far in the literature which are all driven by roll returns. This strategy demonstrates low correlations (below 10%) with the other strategies such as momentum or basis and performs especially well in recessions. Our results are robust after controlling for illiquidity, other commodity pricing factors, and exposure to the aggregate commodity market volatility. The VOL measure is associated with hedging pressure on the futures and especially on the options market. News media also helps amplify the uncertainty impact. Variables related to investors’ lottery preferences and market frictions are able to explain part of the predictive relationship.

Original paper – Download PDF

Here you can download the PDF and original paper of Commodity Option Implied Volatilities and the Expected Futures Returns.

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Author

Lin Gao
Universite du Luxembourg; Luxembourg School of Finance

Conclusion

In conclusion, Lin Gao’s study, “Commodity Option Implied Volatilities and the Expected Futures Returns,” provides compelling evidence of the detrended implied volatility of commodity options (VOL) as a significant predictor of commodity futures returns.

The demonstrated success of a zero-cost strategy, leveraging low and high VOL commodities and yielding an impressive annualized return of 12.66% alongside a strong Sharpe ratio of 0.69, underscores the efficacy of the VOL measure in forecasting future spot components.

Notably, this strategy’s distinct reliance on spot component forecasting, as opposed to the roll returns characterizing other commodity strategies, marks a significant departure from existing literature. The strategy’s low correlations with alternative approaches, coupled with its resilience during recessions, further accentuate its potential as a standalone and robust investment approach.

Furthermore, the study’s findings, robust against control factors and market dynamics, emphasize the impact of VOL on hedging pressure, uncertainty amplification through the news media, and the role of investor preferences and market frictions in influencing predictive relationships.

This research thus bolsters the understanding of commodity market complexities and offers valuable insights for investors and scholars navigating the realm of commodity trading.

Related Reading:

Commodity Strategies Based on Momentum, Term Structure and Idiosyncratic Volatility

Factor Based Commodity Investing

FAQ

What is the main focus of Lin Gao’s paper, “Commodity Option Implied Volatilities and the Expected Futures Returns?”

The main focus of the paper is to explore the forecastability of commodity futures returns using the detrended implied volatility of commodity options (VOL). The study investigates whether VOL can serve as a significant predictor of commodity futures returns and evaluates the performance of a zero-cost strategy based on the disparity between low and high VOL commodities.

What is the key finding regarding the performance of the zero-cost strategy based on VOL?

The key finding is that the zero-cost strategy, which involves being long in low VOL and short in high VOL commodities, demonstrates compelling performance. It yields an annualized return of 12.66% and a notable Sharpe ratio of 0.69. The excess returns from this strategy primarily originate from its forecasting power for the future spot component, distinguishing it from other strategies in the literature that are typically driven by roll returns.

How does the study highlight the uniqueness of the volatility strategy compared to other commodity strategies?

The study highlights the uniqueness of the volatility strategy by emphasizing that its excess returns are mainly driven by the forecasting power for the future spot component. This is distinct from other commodity strategies examined in the literature, which are typically driven by roll returns. The strategy’s reliance on spot component forecasting sets it apart from existing approaches.

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