The past two months have included a lot of “well…I’ve never seen that before” kind of moments.
Even in an environment of firsts however, probably the most unexpected was when the price of the front month WTI oil futures contract traded at a negative number.
On the surface, this is not exactly about options (although if you keep reading, options will make an appearance later) but the pricing mechanics of futures and option contracts are significantly similar, so understanding the events of this week can actually help you gain a more complete understanding of how those markets work.
First, let's do a quick rundown of the fundamentals.
A “Forward” contract is an agreement between two parties to exchange an asset for a specific price on a specific date in the future. “Futures” is simply the term for a forward that trades on an exchange.
There is evidence that some version of forwards have been traded for thousands of years and it’s easy to understand their value for buyers and sellers of assets like agricultural commodities who would like to reduce uncertainty about what prices in the future might be. Those who know they will be buying or selling weeks or months from now can hedge their risk by locking in a price.
Exchange-traded futures have the advantage of standardized terms about quantities, dates and delivery options so that every market participant doesn’t have to negotiate each and every term every time they make a transaction. When someone offers “10 July corn at $3.25,” other traders know that they want to sell 10 contracts of 5,000 bushels each that expire on July 14th at a price of $3.25/bushel.
The vast majority of the commodity futures contracts that are traded don’t end up resulting in the physical delivery of the underlying asset. Most hedgers and speculators take advantage of price action while the contracts are trading, but then close their trades before expiration.
Those transactions used to happen in person-to-person “open-outcry” trading pits, but now they occur almost exclusively in electronic markets – adding a great deal of efficiency as well as instant price transparency for traders and investors around the globe.
In the 1970’s the Chicago Board of Trade and the Chicago Mercantile Exchange added futures contracts on financial instruments like bonds, currencies and stock indices, many of which were settled with cash payments rather than the physical delivery of the underlying asset.
The CME bought the New York Mercantile Exchange (NYMEX) in 2008, adding a portfolio of energy futures and options products to its offerings, including the benchmark WTI contracts.
Exchange clearing houses collect margin deposits from all participants before allowing them to trade and then act as the de facto counterparty between all buyers and sellers, ensuring that the solvency of any given counter party is never a factor. They reassess each account every day to be certain that all participants can meet their financial obligations to the market. With the clearing house acting as the buyer for every seller and vice-versa, each trader is assured that they will receive any money they are due.
Despite the fact that most traders never intend to take or provide delivery, the possibility for actual exchange of assets is the foundation of these markets. The exchange specify one or more locations to which sellers can deliver their goods and where buyers are required to make arrangements to store or transport them away.
There’s an age-old joke from the days of the Chicago trading floors that if a trader gets sloppy and forgets to close out a long contract before expiration, he’ll find himself with 5,000 bushels of corn dumped on his front lawn.
It’s funny, but it’s not even close to true.
What would actually happen is that the trader would receive a receipt for that same 5,000 bushels at one of the 6 acceptable depots in and around Illinois that are detailed in the contract specs. That trader would then be responsible for the costs of storing and/or transporting that corn to another location.
For market participants who don’t have any relationships that would allow them to transport or store physical commodities, those costs add up quickly and will quickly dwarf any apparent profits from a futures trade, turning it into a huge loss instead.
Among the many factors that caused the aberrant price movement this week, the delivery issue seems to have had the biggest impact. It has been reported that all the businesses that can typically be employed to transport or store crude oil in Texas and Oklahoma were at full capacity and not accepting new customers.
Suddenly, traders who were long the soon-to-expire May futures contracts were facing the possibility that they would be forced to accept physical delivery and didn’t have any options regarding what they would do with the oil. Some of them were willing to close their positions at a negative price. They were paying for the privilege of not owning a (formerly valuable) asset.
CME executives had clarified earlier that futures prices could in fact be a negative number, even though it has never happened before. For a brief period, that’s exactly what happened and with one day remaining until expiration, the May WTI contract closed at -$37.63/bbl.
But that’s not even the strangest part…
After clearing trades at negative prices and reporting a negative closing print, the CME announced that it would be possible to trade options with a negative strike price. It makes perfect sense. If a given price is possible for a futures contract, it stands to reason that some market participants would want to trade options at those strikes.
It also presents a truly bizarre complication.
Picture the mechanics of a put option with a negative strike price. Theoretically, you could sell it and collect a premium. Then at expiration, either it would be worthless and you’d keep the premium you collected or the buyer would exercise it – and you’d receive 1,000 barrels of WTI crude and a cash payment in the amount of the option’s strike.
I want to be absolutely clear that I am not recommending anyone sell naked puts on oil. The aforementioned issues regarding the price of storage and delivery could easily erase all potential profits and turn the trade into a big financial loss – as well as a major headache.
I’d also like to point out that there are many other factors that are contributing to the incredible moves in oil prices we’ve been seeing that I’ve left out for the purpose of brevity. The management of the (very popular) USO exchange traded fund – which seeks to replicate the value of a near-term WTI futures contract most likely played a major role in the negative price environment.
Here’s the point I do want to make to options traders:
Fundamentally, options trades break down to a few simple decisions. How much do I pay (or get paid) to enter the position? What are my rights or responsibilities? What assets or cash payments will I be entitled to (or owe) during the life of the trade?
During unusual periods like we’re experiencing right now, examining the potential risks and rewards of options trades can be a very interesting exercise. Remember to be very careful before you trade, however. When something looks too good to be true, it probably is.
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