Commodity Option Implied Volatilities and the Expected Futures Returns

Abstract

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.

Keywords: commodities, option-implied volatility, uncertainty

JEL Classification: G12, G13