Oil Spread Trading – There’s More Than Just 150% Volatility to Consider

This has been a historical week for financial markets in many aspects. For the purposes of this blog, I will focus on the oil markets, which have been devastated by rapid price declines and anemic demand. On Wednesday, March 18, crude oil was down approximately 24% for the day at its low point, reaching $20.52 per barrel, a level not seen since 2002.

The chart below demonstrates the drastic drop in March oil prices. Oil closed the month of February at $44.76 per barrel. Therefore, losing half its value in just 13 trading days. Should I even mention that it started 2020 over $61 per barrel?

I must admit that trading oil in this environment has been both exciting and challenging. A strategy of trying to choose each top and bottom would be pure stress, as a gain could turn quickly into a loss. If one was short the oil market, and kept their positions, I congratulate them on their early retirement. If one is just buying outright put options, that can get expensive at such high volatility levels, and time is working against them.

The swings in oil volatility and price action have reached historic levels recently. Oil volatility has been over 150% numerous days this month, tripling its level from early March. Oil volatility has even seen spikes above 200%. The chart below highlights the CBOE Crude Oil Volatility Index over the past month.

One can also trade spreads in options or futures. Option spread trading can allow for attractive risk-to-return trade-offs, and defined risk limits, if buying and selling several contracts that offset each other on the same side of the market and within the same instrument. An example in crude oil would be:

• Selling 1 July 25 put contract; and
• Buying 1 August 25 put contract.

When spread trading, contracts bought and sold should work together to offset each other. Risk can be fairly controlled in many aspects by choosing from the onset how much to spend on a trade and having loss limits defined by the trades offsetting each other. The value of the spread will still fluctuate due to price changes, volatility, time, etc. until option expiration.

Spread trading has had its challenges this week as well, as spreads have also seen dramatic moves in one more factor: contango, which Wikipedia defines as the following:

A spread position is entered by buying and selling equal number of options of the same class on the same underlying security but with different strike prices or expiration dates.

Contango is a situation where the futures price (or forward price) of a commodity is higher than the anticipated spot price at maturity of the contract.

In simpler terms, prices in the future are higher than current prices. This is commonly seen due to costs involved such as storage, insurance, i.e. carrying costs. When trading spreads, one must take into consideration the contango differences between months. This week has been extraordinary in the price differences between oil contract months, as prices in the future are much higher than prices closer in time.

The prices for the chart below were taken from OptionVue at 12:30 CST on each of the dates listed. The “difference” column indicates the price difference between the November 2020 crude oil contract and the June 2020 crude oil contract. The prices in the future have become extremely high compared to prices closer in time, as oil contracts are quickly sold in the market.

If doing spread trading between months, this “steepening of the contango curve,” along with oil’s large price fluctuations, can result in more fluctuations within spread trading than is normally seen.

Time is typically the cure. As markets settle down, volatility reverts so somewhat of a mean, and those later contracts months become closer as time passes, the contango between the closet month and the next month typically are not as wide, nor fluctuate as much.

Let’s face it, trading futures options can be compared to 3D chess. There are multiple factors to take into consideration and a change in one item can affect another. If not day trading, but rather taking spread positions with favorable risk-to-reward trade-offs, having patience during these strenuous market times is imperative. Spread trading during high volatility can be very attractive. It can help reduce some fluctuations, but not all.