Walking Down the Spreads Line

Dr. Ken Rietz

This is the monthly spreads commentary on commodities. In this issue, we will go over how (and when) to construct a commodity spread for profit. That is, we are not going to be using the spread for a hedge, although the analysis is similar. I will use both fundamental and technical analysis. Most traders use one or the other, each with success. Polls say that 70% of traders use technical analysis and 30% use fundamental analysis, meaning there are lots of people on both sides. But blending the two methods provides a clearer picture, and can keep traders out of trouble, in the sense that each method can detect behaviors and problems not easily visible with the other. When both methods agree, the trade is more likely to succeed.

The commodity that we will be looking at is RBOB, the reformulated gasoline blendstock priced at New York, November 2024 future, specifically RBX24. Here is a chart of that particular futures contract.

Figure 1: The New York RBOB Nov 24 futures, in dollars per gallon

It is clear that the price of RBOB has been dropping lately. More analysis will follow.

Let me deal first with fundamentals versus technicals. The fundamental analyst looks at the external factors affecting a commodity: supply, demand, storage, weather, governmental policies, geopolitical events, and so on. The analyst learns by experience which factors to examine for each commodity. The advantage of fundamentals is that they are forward looking and are much more likely to be able to give a general direction for the price of the commodity. They also are more valid for long-term work, that is, investing.

The technical analyst, on the other hand, assumes that all the fundamentals have been incorporated into a single number, the price of the commodity, and looks at the past prices as the way to approximate the future price. Technical analysis can provide such things as support and resistance levels, trendlines and channels, and can often determine good entry and exit values. The indicators used in technical analysis are generally backward-looking, and therefore of shorter-term usefulness, that is, trading.

Using both fundamental and technical analysis together is therefore much to be preferred. Even if only investing, there is an advantage to taking a good entry point. And even if only trading, there is a huge advantage in finding a long-term trend. And no matter what, reassurance comes when both fundamental and technical analysis agree on a trade.

It is, therefore, a bit unfair to apply fundamental analysis to RBX24, since it is inherently a short- term trade. Nevertheless, it is helpful. Here are the factors that the fundamental analysis would use:

• Supply: Refinery output is the basic supplier of RBOB. It has remained remarkably steady over many years, except for the drop during the pandemic. The refinery output is expected to fall from seasonality. This pushes the price of RBOB up.
• Demand: Gasoline sales account for most of the demand for RBOB. The demand has been at or above 8.8 million gallons a day consistently. No expected motion from this.
• Storage: EIA reports that stocks are roughly 5 million gallons below the 5-year average. This pushes the price up.
• Price of the dollar: If the Fed reduces the basic interest rate by 25 bps, the value of the dollar will drop, causing exports to increase, which will drive the price of oil (and therefore, RBOB) up.

The net fundamental analysis would say that the price is expected to go up. Also note that the relevant topics change greatly with the commodity being examined.

The technical analysis of RBX24 is similar. Here is the graph again, this time with some notations.

Figure 2: The New York RBOB Nov 24 futures, in dollars per gallon

• Price action: The price of RBX24 was in a downward trend, following a downward channel. It then broke downward out of the channel, and then re-entered it and is moving back into the channel. This is neutral price action; it is moving up in a downward channel.
• Trader action: The price of RBOB has gone so low (adjusted) that the net options position nearly turned negative for the first time in modern history. This pushes the price up.
• Support and resistance: Support and resistance levels are prices that the commodity has lingered around enough that there are likely many contracts at those levels. That means that the active price will usually linger there, move slowly for a while, and possibly reverse. For RBX24, the price levels are, roughly, 2.023, 2.048, and 2.125. These are drawn in the graph above.
• RSI: The RSI (Relative Strength Index) is a common way to determine if a stock is oversold (too low) or overbought (too high). On Tuesday, the RSI for RBX24 was exiting oversold, so it can be expected to go higher. However, RSI is not always very accurate, so be careful.

Finally, it is time to construct the spread. Remember that this is not a recommendation, but merely an illustration. The prices will not be accurate, for starters. First, we want a bullish spread, one that makes money if RBX24 moves up, which we expect. You can create

bullish debit spreads (with calls) or bullish credit spreads (with puts). I will use a debit spread, because RBX24 is so low, the puts are likely to be more expensive. For the debit spread, you want to buy the more expensive (higher strike) option and sell the less expensive (lower strike) option. You want to pick the lower strike price to be sufficiently low that the future is almost certainly going to cross going up. In this case, I am picking 195 for the lower strike price. The upper strike price is less critical but needs to be sufficiently close to the top that the price might get that high; this means that you aren’t capping the profit too low. I am picking 217 for the higher strike price.

Pulled together, I am:

Buying the RBX24 195 call

and

Selling the RBX24 217 call

The cost of the 195 call (as of Tuesday close) was $0.0846, and selling the 217 call returns $0.0246, for a next cost of $0.0600. That is the way that the option costs are presented, but the amount that you pay for them is 1 option lot is $42,000 and controls 42,000 gallons of RBOB, so a cost of $0.0600 requires a payment of $2,520.

The behavior of this spread goes this way. The price of RBX24 must go above 195, or both calls expire worthless, and you lose all that you paid. As the price goes above 195, the bought option starts gaining money. Below 217, the sold option remains worthless, but the bought option continues gaining money. If the price goes above 217, the sold option starts gaining money and starts chewing into the profit from the bought option.

The final piece is the objective price and risk price. It would be reasonable to close the trade if the price hits $0.1000 (the objective), or $0.0300 (the risk), and before anything expires. That means risking $1,260 for a potential gain of $1,680.