Thread by @KrisAbdelmessih

Felt cute and looked at some nat gas options on CME's website.

Let's go on a little ride to talk about trade prospecting.

We are going to need some background...

cmegroup.com/markets/energy…

The first thing to understand is the widowmaker spread in commodities is the famous H/J futures spread.

This was the football famously tossed between John Arnold's Centaurus and Brian Hunter's Amaranth.

@HideNotSlide did the story

frontmonth.substack.com/p/amaranthology

The reason it's a widowmaker is because the spread can get unruly.

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future, henceforth known by its future code (H), represents the price of gas by the end of winter when supply has been withdrawn from storage.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, or widowmaker, represents the spread 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)

Today the spread settled at +$1.44 because

H future = $5.437
J future = $3.997

If this in any way felt like a lot, you can turn back now. Equities are calling you.

For the rest of you, we are gonna heat things up and introduce options.

First of all, there are vanilla options that trade on each month.

So there are options that reference the March future and they expire a day before the future (so in February).

Remember H settled $5.437 so the ATM straddle would be approximately the $5.45 strike.

Same deal for April futures. The ATM strike is the $4.00 line.

Strikes in nat gas are a nickel apart.

You can see the J straddle (ATM C + P) settled around $1.14

A quick note.

Commodities are not like equities. Every option expiry in equities references the same underlying...the common stock price.

If you traded Sep, Oct, Nov, or Dec SPY options they all referenced the same underlying price.

In an equity, the December 100 call cannot be worth less than the November 100 call because arbitrage.

If that's not clear, abort now. The rest of this 🧵will hurt.

There's plenty of basics out there and its totally awesome that you get to learn a new world. But not here.

Because H =$5.437 and J = $3.997, you are already in the twilight zone.

The H $5 call is almost .44 ITM and the J $5 call is a full dollar OTM!

So 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.

The reason is the H implied volatility can so far north of the J vol that it can swamp the 1 month time difference.

In an equity, March and April options would reference the same underlyer so owning April vol exposes you to the March vol.

In other words, the March vol is embedded in the April tenor.

Not true in NG.

H and J are not fungible. They are deliverable at different times. If you need H gas, you need H gas. It's cold today. You cannot wait for J gas to be delivered. You won't need it then.

This is generally true in commods.

There is no arb to a backwardated market.

A contango market can be bounded by the cost of storage, but the steep contangos of oil in Spring 2020 and around the GFC are lessons in "limits to arbitrage".

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.

Ok, things are going to get weirder.

You can also trade options directly on the H/J futures spread. Since H/J is considered a calendar spread, the options are cleverly named:

Calendar spread options. But the cool way to refer to them is CSOs.

Let's talk CSOs.

We established that the H/J future spread is $1.44

You can buy a call option on that spread. Say a way 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).

Oil is typically a contango market so a common CL1-CL2 spread will trade -.40

Meaning the front month trades .40 under the second month.

CSO trade on these negative spreads as well. If somone buys the -$1.00 put they are betting the market gets even more steeply contango.

I'll pause.

Right now, you are playing the "so if I buy the -$.25 call, I'm rooting for...ahh, CL1 to narrow against CL2 or even trade premium into backwardation" game.

It's ok. This is supposed to hurt. It hurts everyone's head when they learn it.

Luckily you can re-read.

It's time to look at some prices from today's settlement.

H settled $5.437
The H 15 strike call settled $.42

H/J spread = $1.44
H/J $10 CSO call = $.38

Let's play market maker.

You make some markets around these values.

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 just legged this trade for zero.

You are now 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

How about 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

But that's kinda wild. 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 and the $10 CSO call you are short expires OTM and the vanilla H 15 call earned you $1.00

Now you made 1000 ticks.

This is all fine and good to play with in your head but in reality, mark-to-market, path, margin play a huge role. The vol surfaces for these products are totally 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 its very far out of scope.

But I want to bring this back to the reality at hand.

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 be nuclear.

Why?

Because it's not clear how high the price can squeeze BUT...

The MOST likely scenario is the price collapses back to $3 or $4.

Let me repeat how gnarly this is.

The price has an unbounded upside, but it will most likely end up in the $3-$4 range.

Try to think of a strategy to trade that.

Good luck.

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 market places very little probability density at high prices but this is very jarring to people who see the jacked call premiums.

That's not an opportunity. It's a sucker bet.

Let me show you what's going on with the CSOs...

I made this from today's settlement prices.

The CSO options tell us that the H/J spread has roughly 3% chance of settling near $2, a 2% chance of ending near $3 and 0% really of settling anywhere higher than that.

The reality is the spread almost always settles....at zero! When H expires, it is basically going to be at the same price as J.

And yet the futures spread is trading $1.44 today, and the options fully expect it to collapse.

Now, I know nothing of gas fundamentals. And none of this is advice. And I'm not currently up on the market, but I am explaining how these prices look so crazy (as in whoa look at al this opportunity) but it's actually fair.

The market does something brilliant.

It appreciates path while never giving you great odds on making money on the terminal value of the options.

Now, how do you make money without a differentiated view on fundamentals in such a market?

2 ways and they are general lessons.

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.

That however is not a trade. That's a business. It needs software, expertise, relationships.

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 prices 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.

I called this meta because that's what trading is.

Why would you slug it out in smart markets? Use them to find trades in markets that radiate away from them that are not incorporating parameters from the smart market fully.

Anyway, that's what prospecting is.

Good luck.

And don't trade gas with money you can't lose.

(btw if anyone has cool ideas that radiate from NG and you thought this thread was cute, DMs open and all)

Stay groovy!

I cleaned up this thread, refactored it, and added more commentary in the perma post:

moontowermeta.com/what-the-widow……