The Spread Trader is now it’s own newsletter.

I discounted spread trading.

It seemed a little bipolar to me.

Go Long.

Go Short.

I was missing out.

A sound knowledge of the mechanics of Spread Trading is sooooo important.

I am learning.

I hope you learn with me.

Trent

Now Brent Futz.

The Spread Trader.

On April 20^th, 2020, the May WTI crude oil futures contract traded at negative values, a milestone for the commodity futures trading community (chart 1).

The events of April 20^th provide a case study for students of commodity futures markets, professional traders and regulatory bodies. 

$OIL ( ▼ 0.07% ) $CL_F ( 0.0% )

Chart 1: WTI Crude Oil Futures

In order to understand the events of April 20^th, it is important to put the market into context.

Firstly, April 20^th represented the last trading day for the May 2020 contract, and the open interest of the May contract was approx. 100k, an amount substantially higher compared to historical records.

Given that April 20^th represented the final stage of the liquidation phase of the May contract the unusually high open interest should have been an indication of an unorderly liquidation of a futures contract. 

Secondly, leading up to April 20^th, spread traders were fully aware that the liquidation phase of the May contract was not proceeding as usual.

The most important indicator for spread traders of an unorderly liquidation was the orientation of the May/June spread.

Prior to April 20^th, the May/June traded to a contango orientation of $8, a value significantly greater than full carrying charges (approximately $.30).

Spread traders recognized that the May/June spread was a unique and one-time event in the sense that the May contract was disconnected from the deferred WTI contracts in any meaningful way.

Spread traders recognized that the May contract had become a “falling knife”, capable of defying any rational fundamental or technical analysis. 

The consequences following the events of April 20^th were very substantial, in particular for those participants exposed to the May contract.

Specifically, there was a substantial transfer of wealth from the long to the short that challenged any existing risk analysis.

The fallout also challenged the integrity of the contract.

For perpetual long participants it should have been clear that the excessive contango spread presented an unsustainable condition, that is, the excessive contango orientation countered the effects of an adverse increase in price.

Following the events of April 20, 2020 crude oil spreads reverted to levels less than full carrying charges, that is, the spreads moved from an excessive contango orientation towards full carry.

Currently crude oil spreads are oriented in a backwardation relationship (Chart 2).

Chart 2; July 2026/ Aug 2026 WTI Crude Oil Spread

An important takeaway from chart 2 is the dramatic volatility in the July/Aug beginning with the last trading days of February which coincides with the start of geopolitical events surrounding the Middle East.

Chart 2 presents a classical example of a futures market placing a premium on nearby supplies because of a perceived shortage.  

In conclusion, the events of April 2020 make clear that the opportunity for the market to arbitrage successive contracts related to full carrying charges is perhaps the most crucial characteristic of an effective futures contract.

In the event that the opportunity for arbitrage is eliminated, it is possible for the events of April 20^th to be repeated. 

Another takeaway from the above examples relates to the intersection between a spread trading strategy and fundamental and technical analysis.

An effective spread trading strategy built on a well defined set of criteria will serve to stand alone as a strategy or complement any existing strategy.

Happy Trading

Life’s Good

I enjoy discussing the markets.

Reach out to me with any questions:

Trent Klarenbach

306-463-8607

[email protected]

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Nothing written, expressed, or implied here should be considered investment advice or an admonition to buy, sell, or trade any security or financial instrument. As always, do your own due diligence.