How does derivatives positioning affect the oil market?
Here's another options thread, courtesy of Hari P Krishnan and the Allasso analytics engine. We’ll focus on crude oil, taking some inspiration from SqueezeMetrics andI Ilia Bouchouev along the way.
Dr Ilia Bouchouev, industry expert and author of the excellent Virtual Barrels, has stressed that derivatives markets drive prices far more than physical transactions in oil.
Motivations vary for taking derivatives positions
After all, notional derivatives flows exceed actual consumption by a factor over 50X. Investors take derivatives positions for a range of reasons – catching a trend, arbitraging spreads, hedging against inflation and betting on global economic growth. This goes far beyond the need to lock in the price of a barrel of crude and ultimately leads to a tug of war between commercial hedgers and speculators.
Producers are incentivised to sell futures and calls into rallies, while rolling up their put strikes. This should dampen price increases. Following the mighty lemon, if producers are short calls, dealers will be long and their delta hedging will compress realised volatility.
In the median case, we wind up with rallies that are bounded by the “options wall”, ie, the front month call strike with highest open interest. The chart in Figure 1 has been taken from the Allasso Copilot.
Every so often, in a feedback loop created by momentum driven speculators, prices spike above the wall and can rise much further. For example, in March 2022, the 90 strike call wall was smashed, with futures rising above 120, removing the dampening effect of dealer hedging.
Following on from my book, Market Tremors (co-authored with Ash Bennington), while the initial impetus for the price increase was a combination of the war in Ukraine and post-pandemic recovery, prices moved far further than expected based on market positioning.
The backtest in Figure 2, taken from the Allasso engine, tells the story. If we buy a 50 delta, 20 delta 1x2 call ratio, we harvest a risk premium.
However, premium harvesting carries embedded risk. Most of the time, we benefit from an overpriced call skew, given downward pressure from producers. However, there is always the possibility that speculative frenzy, after an initial random shock, will run us over.
Asking “why” oil prices didn't move as much as expected, for example, given a geopolitical event, can be a futile without an understanding of the internal mechanics of the system.
As always, not to be taken as trading or investment advice.
