Traders with bearish views of the economy need to tread lightly while commodities are at current prices. Due to easy money, algorithmic trading programs, a shrinking world and massive geopolitical risk, playing any market with an easy defined “buy” or “sell” stamp on it can be a difficult trade to sit through. In a market like energy, it can be downright deadly for those without massive pockets.
The Heating Oil, Natural Gas and Gasoline markets are displaying the bearish fundamentals that I’m looking for, and these markets are ripe for this kind of strategy. The market has priced in a hefty premium from assumptions that a war and supply shortages are just around the corner, but the term structure is still showing a carry (front months cheaper than deferred contracts). With our supplies in gasoline and crude near recent highs, the opportunity to short this market is at hand. Under normal conditions, this market would be ripe for the picking by the short sellers via straight sells or put purchases, but due to the aforementioned circumstances, it hasn’t been that easy.
Is there anyone short crude, gasoline or heating oil right now? The last few COT reports haven’t shown that there are many – and for good reason. Who wants to be short on a market that has the capability to rally 10% from the rattling of a sabre? Who in their right mind would want to take home a short position in gasoline when a powder keg is sitting on top of the world’s largest energy exporters?
For those of you who raised your hand, there is a way to take advantage of these bearish fundamentals without having to be tethered to your PC or newsfeed waiting for the next war rumor to send crude 5% higher. Look to the bear futures spread. We have touched on spreads in the past in a previous blog article. For those who are not familiar, a bear futures spread involves the simultaneous sale and purchase of contracts in different months in the same commodity. Any spread that involves the purchase of the back or deferred contract against the sale of the front or near term contract would be considered a bear spread. These types of spreads tend to work better in markets like the current energy market, where the supply is plentiful and the demand is waning.
The idea for this trade is to get into the spread sixty to ninety days ahead of first notice day. Do your technical homework to try and get into the position while the speculative “froth” is pushing the front month higher. When the time is right, sell a nearer month, such as May, and buy a deferred contract, like July or August. You can spread the months as far apart as you like, but the rule of thumb should be the more time between the month bought and the month sold will equate to more volatility and profit/loss potential in the spread. Those with smaller accounts should look to spread no more than two to three months apart. This type of position affords the trader a partial shield against the volatility that has been running rampant in the energy markets. The fact of the matter is that short term supplies are there for these commodities – the inventory reports confirm that. As each contract comes up for delivery, the longs in the market who don’t intend to take the product will roll into the next month. As of right now, with supplies where they are and storage costs bidding up, the majority of spec funds aren’t taking delivery. This type of behavior should show up in the spread price as delivery approaches, helping the spreads widen in the carry market.
These spreads should continue to work as long as the supplies remain high. If you do participate in these kinds of trades, it is important to pay attention to weekly supply data that comes out mid-week via the Department of Energy and IEA. If supplies start to tighten and usage begins to ramp up, it may be time to take a new approach. If this would happen, we should see a backward market. If that were to occur, a new approach should be explored.
For more help applying these types of trades to your account and risk profile, give us a call at 800-800-3840.
Free eBook: Guide to Futures and Spread Trading
This comprehensive ebook, compliments of Guy Bower, includes 40 pages of information and is designed to help you understand and master the fundamentals of futures spread trading. Get your complimentary spread trading ebook today!.