NBP gas volatility surface evolution16 Apr, 2012
For many years the UK gas options market was dominated by Over-The-Counter (OTC) trading, until ICE listed options on the underlying NBP futures contract in March last year. As we highlighted in a previous article the new options contracts have become a transparent source of implied volatilities for different strike prices, allowing a volatility surface to be constructed for the first time. It has now been over a year since the listing of the contract and growth in liquidity has increased the credibility of implied volatilities as a source of market information for valuation and pricing of vanilla options and structured contracts.
An unexpected boost to liquidity?
There has been consistent growth in the trade volume of the ICE NBP option since it was launched, as shown in Chart 1. ICE have also now launched TTF options as well although there has been very limited liquidity to date.
Source: Timera Energy based on ICE traded volume data
It would be reasonable to expect that the listing of the ICE NBP option would draw liquidity away from the existing OTC options market. However, somewhat surprisingly the ICE options have actually boosted OTC options liquidity rather than eroding it. This has been driven by hedge funds trading the ICE options with banks which in turn have hedged their exposure in the OTC options market, boosting overall liquidity. In essence, it has allowed the hedge funds to access to the gas options market without having to go physical. To trade options on underlying physical delivery in the European gas market involves developing an operations capability and negotiating a number of counterparty master agreements which often have bespoke and onerous credit requirements. This is often a significant barrier to entry for many hedge funds and banks.
Dimensions of a volatility surface
For those readers less familiar with volatility surfaces it is worth revisiting the basic definition before examining one. The most common form of a volatility surface involves plotting implied volatility against maturity and option strike price. There are also alternative definitions, such as replacing the strike dimension with the option delta. As the surface is generated from traded options prices it is common to have a separate surface for puts and calls. Plotting the volatility surface facilitates an understanding of two key relationships: the term structure of volatility and the volatility smile illustrated in Diagram 1.
Diagram 1: Volatility term structure and volatility smile
The term structure of volatility describes the relationship between volatility and time to delivery or maturity. In commodity markets volatility typically increases closer to delivery (i.e. volatility for contracts closer to delivery will be higher than for those further out on the forward curve). A simple explanation for this relationship is that complex commodity supply and demand fundamentals become clearer and therefore shocks in the fundamentals have a greater impact on prices closer to delivery. This is exacerbated in the power market where difficulty with storing power drives higher prompt volatility.
A volatility smile describes the relationship whereby the implied volatility increases relative to the “moneyness” of the option, i.e. how far in-the-money (ITM) or out-of-the money (OTM) the option is. This is illustrated in the right hand chart in Diagram 1. In some cases this relationship may be skewed in one direction (for example, a reverse skew or “smirk” describes the case where implied volatility is higher for lower priced strikes).
As implied volatility is a function of the premium that traders are prepared to pay for an option with a given strike, it gives an indication of the underlying level of demand and supply for options at that strike. For example, if the implied volatility for OTM calls is significantly higher than ATM volatility it may be driven by strong demand for gas buyers looking to hedge themselves against higher prices. Liquidity across the different strikes also plays a significant role in determining the shape of implied volatility relative to the strike.
Both of these features can be seen from a recent implied volatility surface for ICE NBP options shown in Chart 2 (this particular surface is for calls).
Chart 2: Implied volatility surface for ICE NBP call options
Source: Timera Energy genereated from ICE NBP options settlement data on 23rd Feb 2012
The chart provides an almost textbook definition shaped volatility surface. It has a clear declining volatility term structure but with higher volatilities in winter periods (another common feature in power and gas markets). Compared to surfaces from the early days of the contract listing, it has a more clearly defined volatility smile across the more liquid maturities (e.g. winter 2013). Although care should be taken when interpreting this, as ICE applies interpolation to generate prices (and therefore implied volatilities) for strikes that fall between actual traded strike combinations. As such a defined shape can be driven by very limited trading activity.
Uses of implied volatility surfaces
The key use for volatility surface data is as a market source of information for valuation and risk analysis for both front office and middle office/risk control functions.
It is unlikely that traders and analysts will directly use the surface in their models, as any shape on the strike dimension is driven by a limited number of trades. It is more likely to be of use in informing internal views of surface shape. Middle office and/or risk functions can use volatility data as inputs to options portfolio valuations and risk measurement calculations as an alternative to Tullett Prebon implied volatilities, traditionally the single source of market volatility information. For these teams the key advantage of the ICE implied volatilities is allowing transparent additional market information (in terms of how volatility changes with strike) to be incorporated into calculations thereby increasing the accuracy of results.
The value of market information for both traders and control functions is driven by the liquidity behind underlying products. The fact that both are actively considering making use of implied volatility information in their analyses suggests that the market is getting increasingly comfortable with the level of liquidity behind ICE NBP options.