There are currently hundreds of millions of tonnes in open interest across ICE and EEX’s Dec-18 EUA options, with a sizeable portion of that ‘in the money’ based on the underlying futures trading around €20.
Many have attributed the rally that saw front-year EUA prices hit a 10-year peak of €25.79 in September, and the wild volatility that ensued, to speculators going long via options positions, specifically call spreads, ahead of the Jan. 2019 start of the supply-curbing MSR.
A long call spread involves buying call options for the right to buy EUAs at a specific strike price, and then selling calls at the same expiration but at a higher strike price.
Under this strategy, a trader can earn as much as the spread between the strikes, minus the net cost of the options, while limiting risk to losing only that net cost.
It lets them squeeze more profits from the widespread bullish conviction that prices will rise in the years to come, as they also benefit from the wild fluctuations while protecting themselves from downside risk.
Beyond the spawning more volatility, options trading veteran Tobias Munk says this also translates into additional risks in the form of unwanted exercises and ‘pin risk’ ahead of the Dec. 12 options expiry.
Once a year, the focus of EU carbon traders points towards an otherwise obscure corner of the energy market spectrum: the expiry of EUA options. But this year, more so than in others, interest in the contracts is heightened by the record amount of outstanding open interest on them. In addition, 2018 is the first year that EUA options are traded on two different exchanges, which is adding an extra layer of complexity.
WHAT MAKES AN OPTION AN OPTION?
Long options are rights but not obligations to buy (calls) or sell (puts) the underlying commodity at/until a certain time for a certain price.
The problem is that on ICE, the options holder does not possess the right to decide if he wants to exercise an option or not. The exchange decides that for them. Everything that is at least 1 tick in the money versus the settlement price will be exercised, and the rest expires. At first glance this seems like a sensible reduction of workload that would be otherwise placed on the trader. That is unless one looks at some fairly common scenarios that tend to happen quite frequently due to the battle between long gamma and short gamma options players. (Gamma is the rate of change in an option’s delta. Delta measures how much that option’s premium changes based on a 1-point move in the underlying asset.)
On EEX, the trader has between 1800 and 1845 CET to inform the exchange about any out-of-the-money options that they want to exercise, or in-the-money options that they do not want to exercise.
Now the question is: why would anybody ever want to not exercise something that is in the money? Well, it could just be just 1 cent in the money and make the options holder unwantedly long in the futures the day after expiry. A €20-strike call held in 1000 lots with the settlement price at €20.01 will result in a 1000-lot long position in the futures, equivalent to a million tonnes. If the underlying EUA futures spent most of the expiry day below the strike price then the trader most likely expected the option not to be exercised. If the future skips over the strike in the settlement window, there would not be enough time to sell the futures before the close, resulting in the desire to abandon the option – which on ICE is not possible.
Off all EUA options open interests, the €20 calls have the largest outstanding positions. The €20 strike was mostly part of higher call spreads like the €20/25 or €20/30, or any other combination that traded over the months with the €20 strike as the lower leg. That means speculators are long this strike, which makes things very interesting. Call spreads are hard to hedge with a long time to go, but as expiry comes closer, the spread dramatically gains in deltas and becomes hedgeable. So above €20, these speculators are able to sell a lot of deltas and below €20 they are able to buy a lot of deltas back if they sold some.
And that is why I think the €20 strike acts as the big attractor this expiry. Getting pinned on that strike price is a real possibility. By selling above and buying below the ranges around €20 become smaller and smaller and that is what getting pinned is.
It is always a battle between the long options holders and the short ones. During quieter times, it is the longs that seem to have the most to lose. Facing an enormous erosion bill, they are keen to lock in any profit they can make and therefore are selling on up-moves and buying on down-moves, thereby compressing the range until it hugs a strike.
With the Brexit vote in the British parliament scheduled for the Dec. 11, this year offers some extra excitement on the day prior to expiry. It is quite possible that we will see a larger move on that day due to the binary outcome of that vote. This, in turn, might give shorts the weaker hand this expiry, which makes for larger swings as they have to buy above a strike and sell below a strike, thereby exaggerating any move.
So it comes down to who will blink first: the longs or the shorts? If the days leading up to expiry are calm, the longs will hedge aggressively and get us pinned. However, if the days are volatile, this will result in wilder swings.
MIGHT NOT BE FLAT
If one bought and sold the same EUA options for the same quantity then one would expect to be flat, right? Not if this was done on EEX. One might just be holding a long and a short position at the same time. In 99.9% of the cases, this is not an issue. The exchange does not charge for exercises, though a clearer might. But recall that on EEX, one has the choice to do uneconomic exercises. So if a trader is short and long, expecting both contracts to be exercised in full, they might not actually be so lucky if the option in question is a strike close to the settlement price.
All of this is the result of a missing flag in the broker give-up procedure that clarifies if a trade is an opening or closing trade. The EEX Eurex system demands this clarification, and as things stand all the broker give-ups are opening trades by default. If a trader has access to the Eurex system, it can apparently manually flatten a position, as can a clearer.
Tobias Munk is a long-time commodity options trader experienced in building profitable options trading desks. If you need help, get in contact at email@example.com or +41 78 703 1321