Only know equity options and read the Black(76) model, but wonder where does the curve (contango/backwardation) factor (rolls) into the options pricing?
curve shape on futures options
- Thread starter blueraincap
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If I understand you correctly, the contango/backwardation of the terms should be of no consequence (except for bias for expected vol direction), as the IV in the options are still just a function of that tenor and strike. The Black(76) model still works. Look at the VIX options (but with proper iv derivation -- not TOS or other one-size fits some implementations). An exception would be some of the dual tenor instruments such as UVIX, but the post was "futures options".
I assume we are talking about commodities here (cause rate futures would be yet another animal) so it's a a broad topic, but here are some discrete points:
* options on futures usually have inverted volatility surfaces because prompt contract is the most volatile (so volatility ramps up as futures approach the expiration - so called Samuelson effect).
* because each expiration has a different underlying, a lot of normal logic about term structure does not really work and forward vol is very difficult to think about.
* in some futures markets, there are options on curve spreads as well as options that expire into a longer-dated futures which allows for some interesting term structure plays as well as various ways to isolate vol
No consequence? Like irrelevant if the underlying is in deep contango vs backwardation? Hard to understand. I mean, the curve is a factor for the underlying to drift up or down, right
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Can you provide specific example? -- When you refer to futures, futures options, and contango/backwardation, roll ... My mind goes to thinking of /VX futures. However, you may be referring to something else. Too much loose terminology around to lead us off the garden path. I'd prefer not to miss interpret.
I mean, for say cocoa futures which are in deep backwardation, the options 3months out (say now is Jan and so April expiration) have the May futures as underlyings. By April expiration, the underlying is expiring next month and the futures should have rolled up 3 months? So my question is how does that roll-up get reflected in options pricing?
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While I don't have familiarity with options on Coco futures or similar products, I do on VIX options (which are on /VX Futures). I don't follow your reference to "roll-up" in this context. Are you wondering about the pricing of time spreads in Coco futures? -- I suspect I am not on the same page as you. Perhaps others may better understand.
He's got a point, actually. Futures vol (including VIX futures, but for a different reason) tends to increase as the contract approaches expiration. While it does not change the pricing in the strictest sense (since IV is backed from the price), it does change the idea of your expected vega PnL, your implied/realized relationship and finally your expected decay. Even in the context of a single option, it matters a fair bit.