Futures Options and Calendars near expiration

Trading futures options vertical spreads and futures calendar spreads can have their own nuances when the trade gets close to expiration. Here we look at some real life examples from our Natural Gas /NG trades in the past few months.

Future Options Vertical spreads

What happens when both legs of a natural gas spread trade expire in the money at expiration ? Unfortunately in our case here this was full loss on a bull put spread, however given that the natural gas /NG price moved about 14% against the position, we are grateful for the protection afforded by the spread to limit the loss.

NG Mar 2016 Bull Put Spread 20160328 Trade Exit Chart

Both legs of the bull put spread got assigned into their respective futures positions at the option strike price, then they immediately get liquidated because they cancel each other out. This is literally buying and selling the same futures contract at the same time at two different prices. This results in an instant profit or loss, depending on what the spread was. The following trades highlighted in red show this exact process. Note that the trade times are all identical, because this was instantly matched by the futures clearing system.

NG Mar 2016 Bull Put Spread 20160328 Trade Exit

Although the future is assigned to the underlying commodity, these are options on futures that settle to the futures. Importantly the options expire a few days before their underlying future does. This gives you a few days so you don’t end up the proud owner of 10,000 million British thermal units (mmBtu) of Natural Gas!

Fear of Futures Settlement

There are several important dates: option expiration date and futures expiration date. On option expiration if your option is in the money, will be assigned into the futures contract.

If you own the underlying future on the future expiration date and it is NOT cash settled, then you could theoretically be made to deliver or receive the contract amount of the underlying commodity. In practice many brokers will monitor their clients positions and start contacting you if you have a commodity futures contract that requires physical settlement expiring in the next week. For example Interactive Brokers will email you 7 days before the futures contract expires to remind you of your responsibility. They additionally point out that they will liquidate the position on the final trading day if it looks like you are in danger of taking physical delivery.

Obviously for something like natural gas that is (probably) not desirable. However it is conceivable that someone might wish to talk delivery of precious metals, but most future brokers won’t let you.

Futures Calendar Spreads

Futures Calendar spread are buying one futures contract in one month at the same underlying, then at the same selling the same underlying futures contract in a different month. Typically “buying” the calendar spread is short near month, long far month. “Selling” the calendar spread is buying the near month and selling the far month. Typically being long the near month implies a bullish position on the underlying price. Being short the near month implies a bearish position in the underlying. With a futures calendar spread you are looking for it to move in a particular direction. The actual credit or debit received isn’t at relevant as the value you can take it off for. You are literally playing the near month contract against the far month contract, as a relative trade. That is of you are bullish you are betting that the near term contract goes up faster than the far month contract. Obviously they will be correlated and almost definitely move in the same direction, but you are playing the rate of change in the spread between the two contracts – basically a very highly correlated pairs trade but that can still move enough to profit.
Traditionally this is seen as a less risky way to express direction on an underlying. For example a natural gas futures contract for the near month could have a range of $5k a month, but the spread would only move up to $1000. This is reflected in the margin for a calendar spread which can be only a few hundred dollars, so the return on capital can be very good, even if the risk is controlled.

Also calendar spreads seem to see wilder less predictable swings into expiration. These do not always reflect the original trade result, even if the underlying moves as you actually expected. Usually a long near month, short far month futures calendar is typically bullish the underlying. For the example the following chart shows a recent /NG calendar, that was originally trading nicely with our original bullish intent up to about a week before expiration.

NG Mar 2016 Short Futures Calendar NGK6 - NGN6 20160422 Trade Exit

Then the spread suddenly reversed course, even though the underlying near and far month natural gas price went up. The differential between the near and far month changed from as expected in the early part of the month, to significantly inverse in the last few days. This actually ruined a profitable trade very quickly which was unfortunate. Moving from $360 profit to $110 loss (that could have been worse it went as low as $360 loss before we traded out of it). It is important to note again that the underlying price went up, which is what we were hoping for – yet the spread reacted opposite to what we expected. Lesson learned : take a spread profit when it is there, and don’t hang around too long into unpredictable expiration to squeeze out the last little bit of profit.

BTW – This chart was created after our trade has expired using this free historical future calendar online charting tool. This is really useful for checking historical performance quickly, especially to observe historical future calendar spread behaviour into expiration – so you know potentially what to expect in the future.

So what is the conclusion here?

The liquidity for futures contracts typically dries up a lot in the last few trading days of it’s life. This is typically because many traders have rolled their positions to the next futures month.

Combine that with the threat of broker liquidation at unfavorable prices, there is typically not much to recommend trading the final 5 days of a futures option or future contract.

Trading Small with Futures Options

Futures are very large principal products and the underlying value of a single futures contract can be anywhere from $23,000 for natural gas /NG and up to $160,000 for US Treasuries /ZB. This means that for many accounts trading them is prohibitively expensive. However fortunately there are options on these underlying futures, that provide a good amount of leverage. Using futures options it is possible to create trades that only risk a hundred dollars or less to make a few hundred dollars or more. These can have a risk reward of for example 1 to 3 (risk $100 with max profit of $300). This means that you can easily construct trades to work within a portfolio of smaller size for example $50,000. using futures options also allows you to benefit from time decay and also high implied volatility on the underlying (similar to standard equity options). this gives you a lot more flexibility than just trading the futures out right long or short.
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OIH – Trade Entry – 19-Dec-2014

OIH150123P34PUT (OIH) MARKET VECTORS ETF JAN 23 15 $34 (100 SHS) Long 5 contracts $0.62/Share $308.92
OIH150123P35.5PUT (OIH) MARKET VECTORS ETF JAN 23 15 $35.5 (100 SHS) short -5 contracts $0.95/Share $473.11

Total income: $165
Total risk: $575
Risk reward: Approx 3.5 to 1

Trade was a little rushed into due to work commitments and only got it on at the close on Dec 19th.

The right direction, but poor execution in a weekly context (better execution available almost anytime this week). However IV is high enough and it is 40% OTM and direction in Oil should be “up” into the new year. Probably will be ok, but may give some stress next week.

 

VLCCF – Trade Entry – 19-Dec-2014

VLCCF has sold off massively into year end, mainly due to oil price. All small cap shipping stocks have been destroyed. Fortunately we sold 200 shares for about $14 earlier this year, so we have about $1000 profit to play with. So in Nov 2014 started selling puts against the position, with a view to getting either extra income or being assigned. Vol was high, so was a good play, however was still “early”. Sold $7.5 Dec 2014, when VLCCF was approx $8 in mid Nov, but got totally caned in Dec (but still better than buying stock outright). Put will be assigned (deliberately) today on 19th Dec at expiration on the close today.

Table below summarises our stock position, which has an unrealised loss of approximately ($8.08 average price - stock close price $4.71 x 560 shares = -$1887). However we realised a gain earlier in the year (May 2014) of $1011, selling 200 shares at $14.15. So our total loss on the stock is about  -$876. However we have dividend reinvested, so that is lowering the average price as well (hence the 60 or so extra shares, over the original 500 share position). Original cost basis was 500 shares at $9.79 = $4895. So loss is -17%, however given that stock price is down -%52 since purchase, that could be claimed as a small victory.

Our aim is to try and get out of this position, with a patient long term approach coupled with option trades and tactical stock sales to reduce overall cost basis.

Stock Position
Shares
Cost Basis /
Average Price
Cost Basis Principal
Existing VLCCF position3608.873193.2
Dec 2014 $7.5 put assignment (deliberately assigned on 19th Dec 2014)200$6.51300
TOTAL560$8.024493.2

The implied vol is 140% (very high) in Dec 2014, so are looking at volatility strategies, namely selling options. The stock is cheap enough (under $5) to consider very conservative put selling strategies, which when coupled with high IV makes it a good candidate for the philstockworld.com style trade (or longer term premium selling). We havent done this trade before, so will be conservative on the first one.

Look at the option chains for June 2015 shows the $7.5 and $2.5 puts. This trade was executed by selling puts and selling calls (premium on both sides).

VLCCF150619C7.5CALL (VLCCF) KNIGHTSBRIDGE JUN 19 15 $7.5 (100 SHS) -5 $221.07 $0.44/Share
VLCCF150619P2.5PUT (VLCCF) KNIGHTSBRIDGE JUN 19 15 $2.5 (100 SHS) -5 $313.12 $0.63/Share

This makes $221.07 (call premium) and $313.12 (put premium) for a total of $552 if VLCCF finishes in between $2.5 and $7.5 in 6 months time. What are the possible scenarios in Jun 2015:

Closes Below $2.5: This is effectively committing to buy 500 shares at about $2.5 – total option premium of $1.07 (or about $1.43 per share). This would be a bad outcome, and would have average price of about $4.75 on 1000 shares. Assuming stock would not go bankrupt (!) would have to look at option premium trades again (to further lower cost basis), or just buy and hold and wait it out. This would not be good, but would be way better than buy and hold from $9.79 to $1 to $2 range.

Closes Between $2.5 and $7.5: since the IV is VERY high there is a higher likelihood that vol reduces over the lifetime of the trade, so that will also give a way to profit even if stock doesn’t move anywhere over the next 6 months. This is like a “psuedo” dividend assuming the stock stays in a ride range – the options market currently prices this at about at 50% chance of happening, but if the IV comes down the percentage chance of it happening will be reduced as well. The “normal” IV for this stock is about 40% and that would price it at about a 75% of chance of happening (much better odds). The P&L here would be the stock P&L, plus about 5 contracts x $1.07 option premium or about $535 (the “pseudo” dividend). If stock price is over $7 by Jun 2015 expiration then this is breakeven on the currently unreleased open positions, however if you add the $1011 profit from earlier in the year, then the breakeven since position inception is approximately $5 (which looks achievable, and is not a bad outcome given that the position was started at $9.79).

Closes above $7.5 : If the stock is above the $7.5 strike in 6 months, then the entire position will be assigned for a profit:   –  $8.08 average cost basis + $7.5 strike assignment + $1.07 option premium = about $0.49 profit on 500 shares. That would make a small gain on $250, which added to $1011 from earlier this year, would give about a 25% profit on original position (and would have exited with VLCCF position with a decent gain, not having given up on it when it was a loser as it is today).

Note: There are an extra 60 shares that have been acquired due to reinvested dividends, but that would just be bonus profit (e.g. if closed at $10, then would get $2.5 * 60 shares = $150 of extra profit). But that was not included above to keep calculations simpler.