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.

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.