Option market tailwinds

Carbon price near levels where gamma hedging begins

Options activity was a powerful force propelling carbon prices to €90 per tonne late in 2021.

Bullish carbon traders had accumulated huge numbers of call option contracts that gave them the right to buy carbon at a particular price and time: €70, €80, €90 per tonne and so on.

As carbon futures prices rose toward the value of the call option contracts, banks and other financial institutions that sold them found themselves on the wrong side of the trade. The only way to protect themselves was by going long and buying the underlying futures contracts.

As they did, they created a vicious circle where carbon prices rose, banks in turn had to buy more futures contracts, which then triggered fresh price rises, which then commanded more buying. In the jargon of the options market, it is a situation known as gamma hedging.

Early signs indicate a similar tailwind may be developing in 2022.