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In an effort to help market participants mitigate the considerable price risk that is often present between contract months of a futures contract, the New York Mercantile Exchange introduces calendar spread options on its Brent crude oil futures contract.
The contract is simply an options contract on the price differential between two delivery dates for the same commodity. The price spread between contract months can be extremely volatile because the energy markets are more sensitive to weather and news than any other market. A widening of the month-to-month price relationships can expose market participants to severe price risk which could adversely affect the effectiveness of a hedge or the value of inventory. The calendar spread options can allow market participants who hedge their risk to also take advantage of favorable market moves.
To put market relationships in perspective, one must keep in mind two terms which describe the price curve. When the price for a contract month nearer to the present time is higher than the price for a contract further into the future, the market is said to be in backwardation. Typically, this means that prices are high because supplies are tight; in this case, the strike price for a calendar spread options contract will be a positive number. Conversely, when the nearby price is less expensive than the farther-dated prices, the market is in contango. When the price curve is in contango, strike prices of calendar spread options contracts will be negative. A negative price is not unusual in spread relationships.
A commodity's price curve is likely to change over time. Calendar spread options can be used to manage the exposure a business has to these changes.
The risk manager for a crude oil producer will sell futures contracts to hedge production.
In contango markets, the producer, who is a seller of oil, would seek downside protection by buying puts; an oil buyer would purchase calls. A crude oil producer with excess storage capacity can make money when the price curve is in contango by purchasing the cheaper prompt month and selling the more expensive deferred contract month.
When the markets are in backwardation, however, spare storage capacity is an asset that generates no cash flow. Selling put options on calendar spreads generates cash flow, and having the asset as a backstop enables the oil company to sell the put.
Additionally, in a steeply backwardated market, it can be costly to buy back a hedge after it has appreciated in value on its way to becoming the prompt month. Buying calls on the calendar spread can reduce such costs, and can compliment the short hedge by allowing for participation in the rising market.
At exercise, the buyer of a put options contract will receive a short position in the futures market for the closer month and a long position in the futures market for the farther-dated month. The buyer of a call options contract will receive a long position in the futures market for the closer month and a short position in the futures market for the further month. |
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