Let’s start with some background.
Enter the famous March/April futures spread in the natural gas market. This was the football famously tossed between John Arnold’s Centaurus and Brian Hunter’s Amaranth. You can get a good recount of the story here as recounted by the excellent @HideNotSlide.
The reason it’s a “widowmaker” is the spread can get nasty. The March future, henceforth known by its future code (H), represents the price of gas by the end of winter when supply has been withdrawn from storage. April (J) is the price of gas in the much milder “shoulder” month. H futures expire in Feb but are called “March” because they are named by when the gas must be delivered. Same with J. They expire in March, but delivered in April. The H/J spread references the spread or difference between the 2 prices.
If you “buy” the spread, you are buying H and selling J.
- If the price of the spread is positive, the market is backwardated. H is trading premium to J.
- If the spread is negative, H<J (ie contango)
- H future = $5.437
- J future = $3.997
Introducing Options Into The Mix
- H settled $5.437 so the ATM straddle would be approximately the $5.45 strike. Strikes in nat gas are a nickel apart.
- For April futures the ATM strike is the $4.00 line. You can see the J straddle (ATM C + P) settled around $1.14
Commodities Are Not Like Equities
- The H $5 call is almost .44 ITM
- The J $5 call is a full dollar OTM
Despite J options having a month longer until expiry, the J $5 call trades waaaay under the H $5 call.
It gets better.
Even if H and J were trading the same price, the H $5 call can trade over the J $5 call. This is where newcomers to commodities from equities find their muscle memory misfires.
The H implied volatility can go so far north of the J vol that it can swamp the 1 month time difference.
As described earlier, in an equity, March and April options would reference the same underlyer so owning April vol exposes you to the March vol.
Not true in NG.
Severing the arbitrage link between spreads
So we now understand that H and J can become unhinged from each other. That’s why the spread is a widowmaker. It can be pushed around until convergence happens near the expiry of the near month. That’s when reality’s vote gets counted.
More Complexity: Options On Those Crazy Spreads
- You can buy a call option on that spread. You can buy (or sell) an OTM call, like the H/J $10 call.
- You can buy an ITM call like the H/J $1 call. That option is 44 cents ITM.
- You can buy a put on the spread. If you buy the H/J 0 put (pronounced “zero put”), that option is currently OTM. It goes ITM if H collapses relative to J and the spread goes negative (ie contango).
Right now, you playing with an example in your mind. Something like: “so if I buy the -$.25 call, I’m rooting for…ahh, CL1 to narrow against CL2 or even trade premium into backwardation”
Don’t be hard on yourself. This is supposed to hurt. It hurts everyone’s head when they learn it. It’s just a language. The more you do it, the easier it gets and with enough reps you won’t remember what it was like to not be able to understand it natively.
- Suppose you get lifted on the CSO call at $.40 (2 cents of edge or 20 ticks. 1/10 cent is min tick size)
- Meanwhile the other mm on your desk gets her bid hit on the vanilla H 15 call at $.40 (also 2 cents of edge)
Your desk has legged getting long the H 15 call, and short the H/J 10 call for net zero premium. If we zoomed ahead to expiration what are some p/l scenarios?
- H expires at $5 and J is trading $4 on the day H expires or “rolls off”. Therefore H/J = $1
- Both calls expire worthless. P/L = 0
- H expires $15 and J is trading $4 so H/J is $11.
- Ouch. Your long call expired worthless and your short H/J $10 call expired at $1.00. You just lost a full $1.00 or 1,000 ticks. That’s a pretty wild scenario. H went from $5.43 to $15 and J…didn’t even move?!
How about another scenario.
- H goes to $16 and J to $7. So H/J expires at $9.
- The $10 CSO call you are short expires OTM and the vanilla H 15 call earned you $1.00. Now you made 1000 ticks.
It quickly becomes clear that vol surfaces for these products are untamed. Option models assume bell-curvish type distributions. They are not well-suited for this task. You really have to reason about these like a puzzle in price space. I won’t really dive into how to manage a book like this because it’s very far out of scope for a post but it’s critical to remember that pricing is just one consideration. Mark-to-market, path, margin play a huge role.
The truth is the gas market is very smart. The options are priced in such a way that the path is highly respected. The OTM calls are jacked, because if we see H gas trade $10, the straddle will go nuclear.
Why? Because it has to balance 2 opposing forces.
- It’s not clear how high the price can go in a true squeeze or shortage
- The MOST likely scenario is the price collapses back to $3 or $4.
- Wanna trade verticals? You will find they all point right back to the $3 to $4 range.
- Upside butterflies which are the spread of call spreads (that’s not a typo…that’s what a fly is…a spread of spreads. Prove it to yourself with a pencil and paper) are zeros.
The Wider Lesson
So how do you make money without a differentiated view on fundamentals in such a market?
There are 2 ways and they double as general lessons.
- Play bookie
You have a team that trades flow. You are trading the screens and voice, you’re getting hit on March calls over here, you’re getting lifted on March puts over there, you’re buying CSO puts on that phone, your clerk is hedging futures spreads on the screens. Unfortunately, this is not really a trade. This is a business. It needs software, expertise, relationships. Sorry not widely helpful.
- Radiate outwards
The other way to make money is prospecting elsewhere, with the knowledge that the gas market is smart. It’s the fair market. It’s not the market where you get the edge, it’s the one that tells you what’s fair or expected. So you prospect for other markets or assets that have moved in response to what happened in the gas market, but did so in a naive way. A way that doesn’t appreciate how much reversion the gas market has priced in. Can you find another asset that’s related, but whose participants are using standard assumptions or surfaces? Use the fair market’s intelligence to inform trades in a dumber or less liquid or stale market.
Trading As a Concept
The solutions in markets are rarely going to be where it’s easy to see because that’s where everyone will be looking.
If you found CSOs interesting recognize there are physical assets that are just like options on a spread.
- Oil refineries =Heat/Gas crack options
- Power plants = Spark spread options
- Oil storage facility = WTI CSO puts
- Soybean mill that crushes soy into meal/bean oil
If you had a cap ex program to build one of these assets how would you value it? You’d need to model volatility for the spread between its inputs and outputs!
The owners of these assets understand this. They are the ones selling CSOs! It’s the closest hedge to their business.