Walking Down the Spreads Line

This is the monthly spreads commentary on commodity futures. In the past, we have looked at commodity futures spreads for hedging or investing. This month, we will go over the process of creating a calendar spread futures trade, in crude oil. First, we show that the market is ripe for such a trade, then go over the process of selecting the type of trade, and finally get into the precise process of constructing the trade. Disclaimer: This commentary is not to be taken as giving a recommended trade. It is purely for educational purposes.

The first step is to establish which direction the crude oil market is likely to move. For that, we first look at the front month futures values for the past several years. Here is the graph.

Figure 1: The front month futures for WTI crude oil, Source: EIA

The news is uniformly in favor of a downtrend in crude oil:

• The president-elect’s agenda, once he is in office:
• His campaign promise of “drill, baby, drill” will boost supply. It will take 1 to 2 months for this to have an effect.
• His appointment of an oil and gas company CEO to the post of Secretary of Energy
• His campaign promise of lower gasoline prices
• His desire to reduce oil revenue in Russia and Iran
• Tariffs will tend to increase the strength of the dollar, causing all prices to drop
• Reduced demand from China due to a sluggish economy plus increased US production could lead to 1 million barrels/day crude oil surplus
• Oil prices are dropping anyway right now

But are there any forces that would try to counteract that decline in prices? Of course there are. OPEC+, primarily, would likely cut their production to firm up crude oil prices. But the number of countries that would abide by those cuts has not historically been unanimous. And in a difficult global economy, the number of those following the mandated reductions is likely to be less than usual. So, it is very reasonable that crude oil prices will drop, particularly WTI crude, since the price of that variety of crude oil is less affected by OPEC+.

Another pattern in crude oil prices that we could exploit is its seasonality. The graph above for the price of crude oil makes this a less-obvious choice, but it is worth a try. The annual peak of crude oil prices is usually around April, and the price tends to drop until September, in very rough terms. So those two months can be the calendar extent of the spread trade. (Realize that those two months might not be the best some years, but I want to be specific here.)

Now we need to construct spreads on the assumption that crude oil prices will drop. (Remember, this is an educational situation, not a recommendation.) There are two basic directions to go: debit spread or credit spread. The idea of a credit spread is that you are paid up front for establishing the trade, and you want to manage the trade to keep as much of the money as you can. The idea of a debit spread is that you pay money to establish the trade, which is done in a way that you will get more money when the trade is closed than you paid for it. But first, let me go over the risks of each direction.

The credit spread gives you money, but it is entirely possible, if the trade goes against you, that you can lose all of it and more, ending up losing money. The total amount lost can be substantial and is very difficult to estimate. (There is a formula for max loss of a vertical credit spread, but this is a calendar credit spread, which makes the estimation harder.) The debit spread therefore has the advantage here. Your maximum loss is exactly equal to the cost of the trade. From my perspective, that makes the debit spread preferable, and so I will stay with that here. Bear credit spreads might be a topic in a future commentary.

Bear debit spreads use put options. You sell one put option with a closer expiration date and buy another put option with a further out expiration date. In both cases, you use the same strike prices (although this is not essential; you end up with a diagonal spread if the strikes are different). The near strike is not as expensive as the far strike, so you can consider the near strike option as helping pay for the other. In this case, one possibility is to use both options at the money (ATM), or slightly out of the money (OTM) to make the setup cheaper. Use the near option as an April (or later, up until August) expiration, and the far option as September. The spread should be closed before the near expiration, and if the price of WTI has dropped, as we expect, the near option will not expire worthless, but the far option will have gained money as well and the net deal will likely be profitable. There are a variety of ways of enhancing this process, but that also will have to wait for a later commentary.

As a final note, I want to emphasize that this is for educational purposes only. The analysis is sound, but neither the author nor the publisher takes any liability for it. And, of course, you are welcome to use the conclusions here to trade crude oil any way you wish.