crossing the commodity chasm
đď¸Quick note: I went on the Alpha Exchange podcast with Dean Curnutt to chat trading, options, training, weird ETF stuff. (51 min)
Friends,
I was planning to publish a follow-up to last weekâs derivative âincomeâ bumhunting where I look closer at various ETF performances. I started data-wrangling and then got distracted with yesterdayâs trade idea. I will circle back to the ETFs in an upcoming issue.
As far as the trade idea this is what I ended up doing:
Liquidated most of my railroad shares (economic activity play that has held up well in contrast to commods)
Shorted .54 delta calls in November expiry options in WTI. I used Z24 NYMEX crude options which are âDecâ options but expire in November. The nomenclature comes from the commodity delivery window as opposed to the last trading day of the options. Confusing if you are coming from equity land.
Bought Dec2025 WTI futures
On balance, I added overrall risk-on length via the total quantity of Dec25 futures.
The oil legs assumed a .50 beta between Z25 and Z24 so I bought 2x as much Z25 as I sold in Z24 oil delta, which brings me toâŚcommodity analytics. Like where did I get .50 beta from?
For some background, I spent 2005-2021 managing commodity options businesses. Despite moontower.ai being equity focused and the start of my career being in equities, ETFs, and equity options, commodity futures and options are my binkie.
One of my favorite periods of my professional career was building out the analytics for commodities. It was also a clue that I enjoyed building as much as trading. The career is most rewarding when you can not only drive the racecar but drive the one you built.
The analytics were similar to moontower.ai in the sense that they are volatility-centric and ignore fundamental data. But there is a tremendous amount of translation required to think about vol and term structure in the commodity markets.
A non-exhaustive list of features (or bugs) in commodity futures:
Physical delivery and cash delivery nuances
A single order book instead of multiple exchanges
A large, opaque OTC market whose contracts are cleared by exchanges but not traded on them
No insider trading rules
Different rebate mechanisms for volume traders
Less restrictions on market makers taking a âshowâ in voice markets
Even the underlying is highly levered â and exchanges can change margin requirements on a whim
Cross margining of look-alike products (ICE vs NYMEX WTI)
Options on spreads, Asian options, ânew cropâ, short-dated ag options, and 0DTE has existed in these markets for almost 20 years already (but were not traded electronically)
Close to 24 hour trading
Early exercise of calls and puts in a world without dividends or corporate actions
CFTC not SEC
Different arbitrage bounds â a time spread can trade for a credit because each option expiry is tied to its own underlying. This gets very hairy in commodities that are hard to store (ie nat gas or electricity) or highly seasonal ones such as ags which have ânew cropâ/âold" cropâ dynamics that can actually have negative correlations (the performance of an old crop will affect planting decisions for the next season â high prices one year can lead to oversupply the next. Forward vols in commodity markets are a fun topic.
Infrastructure-wise you need a totally different âsecurity masterâ or database mapping between financial instruments.
Underlyings can be referenced by many types of options in various combinations. Crack spreads, crush spreads, spark spreads. Options on all of them.
Every commodity has different expiration schedules, trading hours, last trading time, settlement procedures, naming conventions.
The markets pool liquidity in bespoke ways â October options in cotton are listed but never traded. If you trade nat gas you care a lot about 2 spreads in particular â H/J (March/April) and V/F (Oct/Jan). In RBOB, the gasoline spec for delivery changes in the North American summer.
Your security master needs to be flexible enough to accommodate all this variation. Your front-end analytics are going in the other direction â tuned for the idiosyncrasies of the markets youâre focused on. And then all the risk needs to be reported to central command in a way that fits with the overall portfolio risk while not losing the details when they matter. It is essential for the risk management layer to understand the drivers in these markets to devise appropriate shock scenarios and aggregations.
My first home in commodity trading was the oil complex. WTI, Brent, heating oil and gasoline (RBOB but I started trading it when HU was listed in parallel as the market was migrating to the RBOB spec). In that world you have American-style options expiries spanning from 1 day to many years into the future. You have calendar spread options (CSOs), crack options (I stood next to an independent trader that was long so many gas crack calls when Katrina hit that it was a noble percentage of a dayâs worth of refining capacity in the US), Asian options, and European look-alike options that settled to swaps.
There were active markets in American vs European âswitchesâ. You could exercise an American option for an hour after the market officially closed while the Europeans were cash-settled. If you were long Europeans on a strike, and short the Americans going into a pinâŚwell, the market was gonna help you discover what that switch is worth.
If you trade WTI-Brent âarbâ options, you are trading options on the spread between the 2 oil benchmarks. WTI and Brent have their own supply/demand dynamics because they are in different locations and vary by spec. This means different buyers and suppliers. Refineries optimize their throughput based on what end products are demanded and where (diesel, gasoline, jet fuel, bunker oil, etc). Throw in transportation costs, technicalities, and legality/tariff/sanctions on exports and you have a pair of highly liquid individual markets only loosely tethered by the wire of âarbitrageâ. The arb options are a way to directly trade the spread. And then nerds can then relative value trade the vanilla options on each commodity vs the arb options. Thereâs no boxed arbitrage embedded in the math but the concept of implied pairwise correlation is a tradeable, albeit, messy parameter. And with the different expiration dates and times for the âsameâ month you will find yourself long or short a pile of unmatched option greeks for a string of days in between expirations (which also suggests that getting your volatility calendar correct is paramount).
(This implied correlation idea also exists in the context of calendar spread options. In 2007/2008 there were giant discounts in the WTI option forwards. The time spreads were incredibly attractive. The risk was you were inherently short spread vol so if you believed that the spread vol was highest conditional on the front month futures collapsing, then CSO puts were a clever hedge. The trade set-up was caused by the SEM Group blowout. I feel like I owe their desk a thank you for effectively buying my first apartment for me.)
An aside
The natural gas futures and options world is (was?) the king of cruft. It felt like a racket for churning exchange fees and broker commissions.
Expirations were so cumbersome because the liquid underlying was a physical future but the options that referenced them barely traded â instead the cash-settled options were traded but the cash-settled underlying swaps were not. They werenât even listed, they were only cleared by the exchange! I can still remember being worried that Iâd have an error, outtrade, or unreconciled position contaminate the grid I used to project how many futures I needed to buy/sell above/below each strike to replace the cash-settled deltas that were âgoing awayâ.
Oh yeah, and the swaps themselves had a different expiry than the futures so there were highly active markets in TAS (âtrade at settlementâ) futures, pen/LD swaps (âpenultimate mini vs last dayâ swap spread), âfutures/penâ (physical futures vs full penultimate swap), and the EFS (âexchange for swapâ â last day futures vs last day swap). All of these things are tied together by algebraic relationships so you can triangulate the implied market in one from the legs of the others. Except none of this trades on a screen so you were still doing mock trading math based on quotes you are seeing on AOL IM or YMâŚin the 2010s!
I donât remember the full history of how the markets eased into these conventions but I believe it was the marriage of disjointed OTC, exchange-traded, and physical markets. Iâm not even getting into how the multipliers on these contracts work â if you trade X mmBTUs in the physical market thatâs a size per # of days in the month which is how pipeline operators think and to which the financial players need to adapt.
And just like the oil market, thereâs a NYMEX version and ICE version and sometimes you didnât find out what you got until after the deal was consummated.
Hence venting on my Lost Xtranormal Video (Fonz, remember when we scripted this?)
It remains true that the number of commodities you can trade is much smaller than the number of equities, but there are loads of futures expirations, futures option expirations, strikes, and instruments.
A basic infrastructure starts with the futures chain and term structure. While I donât currently have a proper infra I did grab several years of simple end-of-day WTI futures prices prompted by my oil trade idea.
I got distracted from writing the ETF post into creating a bunch of charts that demonstrate things I like to look at in futures. Iâll share them below and the reason a vol trader should care.
A quick comment on infrastructures.
You should be able to examine futures data in at least 2 ways:
Fixed expiration (ie a history of the Dec24 contract)
This is especially useful for seasonal charts (ie X-axis is Jan thru Dec and the lines are contracts for various years)Relative expiration (ie M1 or CL1)
The ordinal number 1 refers to the first contract listed. This is the basis for âcontinuousâ contracts. Itâs also important because of the Samuelson effect which I mention in the interview with Dean â a contract with 12 months until expiry is less volatile than the same contract with 1 month until expiry. Which is another way of saying the M1-M12 spread has volatility and that volatility has its own properties.
The importance of having both views compounds when we layer in option analysis.
Weâll keep to a tight format. A chart and its relevance. All data is WTI futures settlement on the NYMEX.
[LLM note: To organize the data there was one instance where I wasnât sure the easiest way to do it in Excel. I figured Iâd need a helper column but instead of trial-and-error I just gave ChatGPT a screenshot of the spreadsheet and a description of my desired output. Abracadabra. Even the explanation for how the formula worked was perfect. I donât know how long until itâs here but I feel like sometime shortly, organizing the data, laying out the charts, and the blog post will all be done by autonomous parallel AI agents. Come to think of it, why would I even prompt itâŚthe LLM will just prompt better questions than Iâm bothering to answer just by knowing what data is in front of me and the history of my blog posts.
The movie Fight Club makes more sense to me now than it ever did before.
Nerds being the victim of their own success is the own goal the Colosseum has been waiting for]
Alright, letâs get to it.