The Variance Premium in Commodity Markets

There is an old option trader saying (actually it is possible I made it up, but I’m pretty old), “Equities trade based on statistics. Commodities trade based on knowledge.” This means that if you can successfully trade options on MSFT, you will probably also do OK trading options on any number of other equities. Indeed, most professional equity option traders routinely trade 50-100 different names. Commodities aren’t like this. A good bean trader can’t just start trading corn and expect to be successful. The knowledge of the crop just isn’t directly transferable.

So I’ve always been suspicious of commodities. I don’t like trading something where product specific knowledge is important. I’m never going to be the knowledgeable one in these products. But it is always good to look for new edges so, after some prodding from a couple of readers, I decided to take another look at commodity options. Specifically, is there a persistent variance premium?


The paper,” Variance Risk Premia in Commodity Markets”, by Marcel Prokopczuk and Chardin Wese Simen says there is. They used option prices to construct synthetic variance swaps and found significantly negative variance risk premia in nearly all commodity markets. They examined 21 commodity markets between 1989 and 2011, and found that 18 of the commodities had statistically significant returns to short variance swaps. The table below summarizes the results for the 60 day swaps, and I’ve included the S&P 500 for the sake of comparison.

Commodity
Variance Premium (%)
T-Score
Crude
3.4
6
Heating Oil
3
7
Natural Gas
10.2
9
Corn
2.3
8
Cotton
-0.6
-11
Beans
0.8
2
Bean Meal
0
0
Bean Oil
1
4
Sugar
2.6
6
Wheat
0.7
3
Hogs
1.2
3
Cattle
1
11
Copper
2.4
4
Gold
1
4
Silver
0.2
1
Cocoa
3
8
Coffee
1.7
1
Oats
6.2
8
OJ
2.3
3
Rice
3
8
Lumber
3.5
10
S&P
1.5
3

Table One: The returns to short 60-day variance swaps.

The results look promising but most of these commodities have very low option volume. Given this liquidity issue and the t-scores, the products I would consider selling options on are:

Crude
Heating Oil
Natural Gas
Corn
Sugar
Copper
Cocoa

Commodities still scare me and i'd still want to learn a little about the specifics of each, but the rewards might be worth the nervousness.
Euan SinclairComment