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Do you look at backwardation/contango when daytrading CL?
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Do you look at backwardation/contango when daytrading CL?

  #1 (permalink)
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Do you look at backwardation/contango when daytrading CL?

I was wondering if anybody looks at the shape of the curve when trading CL or any other commodities for that matter. For example, today the market is in contango, so would you only be considering short day trades? Or is it only used best for longer-term trading? Or for spread trading? I can see how in backwardation you could buy the front-month contract for, say $100, then sell the 6-months-away contract for, say for $150, then take delivery and store the oil for 6months, assuming you had the ability to take delivery and store the commodity (this is what a lot of big players did in late 2008).

The shape of the curve doesn't change that rapidly so I'm not sure how useful it would be for day trading. Maybe you could track the rate of change or the direction of the curve's changes to help determine trend.

Notice how high the volume on the June and December contracts on later months is compared the other months near them.

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Surprised @Fat Tails hasn't chimed in here, he usually loves to talk about contango with CL

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Big Mike View Post
Surprised @Fat Tails hasn't chimed in here, he usually loves to talk about contango with CL

Mike

Did not want to argue with @shodson. I think he confused contango and backwardation. For a brief definition of contango and backwardation see the link below.

Usually the crude market is in contango for the next few contract months, which results in rolling losses for long-only funds which only use those contract months to simulate the long position. It is an interesting exercise to compare the forward curves of NYMEX traded WTI futures and IPE traded Brent futures.



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Well, no argument here, I'm not expert in backwardation/contango, I'm just wondering if there's a way to incorporate it into commodities trading profitably.


Fat Tails View Post
Did not want to argue with @shodson. I think he confused contango and backwardation. For a brief definition of contango and backwardation see the link below.

Usually the crude market is in contango for the next few contract months, which results in rolling losses for long-only funds which only use those contract months to simulate the long position. It is an interesting exercise to compare the forward curves of NYMEX traded WTI futures and IPE traded Brent futures.


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shodson View Post
Well, no argument here, I'm not expert in backwardation/contango, I'm just wondering if there's a way to incorporate it into commodities trading profitably.

I do not consider myself an expert either. Of course the forward curve for the futures contracts of a commodity can and should be incorporated into the trading approach. However, the forward curve is more important for position than for day traders.

The graph which you showed is the forward curve, as it shows the current price of different contract months of the same commodity. As it is sloping downward, the market is in backwardation over the shown period. Please make sure to understand the difference between backwardation and normal backwardation. The latter refers to the futures price relative to the expected price of the commodity at expiry of the futures contracts and occurs when the difference between the forward price and the current price is smaller than the cost of carry (storage + financing cost until expiry) for that commodity.

The backwardation as shown reflects tight market conditions right now. It is incentive to sell short the front month contract and go long a distant contract month to lock in the profits. However, you can only do that if you physically own the crude oil required for short term delivery. Somebody not owning physical oil can not profit from this type of arbitrage.

The normal state of affairs would be an upward sloping curve for CL. Indeed the curve is upward sloping for the first few months. Demand is higher for those months as consumers of oil and oil products (refineries, airlines, trasnport companies) hedge the price of their physical supplies.

The short end of the forward curve for CL is nearly always in contango. You can check this by having a look at the offsets for the backadjustment of the contract months. The last negative offset - meaning that the forward curve was inverted between the current front month and the next expiry - occured in September 2008, when the contract CL 10-08 was rolled to CL 11-08. The latest offset - rolling the contract month CL 12-11 to CL 01-12 on November 17 was 0.01. This is the lowest value since 3 years, and it basically reflects an expectation of a weak demand for the coming year.

As a position trader you would therefore think twice about a long position. However, if you enter a short position in the front month contract, you may suffer from a (rare) short squeeze, when you try to roll that position too late.

I do not see a direct relationship between the structure of the forward curve and intraday prices. Nothing I would consider as a day trader.

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hope its not to late to jump on this thread. Fat Tails, can you please explain a bit more on oil arb. if Im in refining business and buying oil, means physically owning and storing it for some time, Im shorting frontline and long lets say 3 months contract:

in 2 weeks time if price goes higher
  • Im ok with physical (but have to refine it)
  • loosing on frontline
  • gaining on 3m contract
the move in front line will be bigger than in 3m so I'll have a loss

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Maxa View Post
hope its not to late to jump on this thread. Fat Tails, can you please explain a bit more on oil arb. if Im in refining business and buying oil, means physically owning and storing it for some time, Im shorting frontline and long lets say 3 months contract:

in 2 weeks time if price goes higher
  • Im ok with physical (but have to refine it)
  • loosing on frontline
  • gaining on 3m contract
the move in front line will be bigger than in 3m so I'll have a loss

Let us assume that are you are in the refining business. Then you have two problems

(1) make sure that your refining business gets you a decent refining margin
(2) manage the market risk of your stocks of crude and finished products

The two problems are not related.

Solution for 1: Now let us assume that today's refining margins are decent and that you would like to lock them in. Then you might do the following

-> enter into a long crude position for the next few contract months
-> enter into a short position for gasoil for the next few contract months
-> enter into a short position for gasoline for the next few contracts months

You would need to calculate the size of your position according to the configuration of your refinery. If you do some hydrocracking, you would allot a larger fraction to your gasoil position and a smaller fraction to your gasoline position, in case your refinery has an fluid catalytic cracker, it would be the inverse.

Solution for 2: The amount of physical stocks is only determined by the operational requirements of your refinery. However, depending on your view on future market evolution, you could hedge your physical stocks to reduce market exposure. Or if you have no view on market evolution and want to avoid to speculate, you would simply define your typical stock requirements, leave those unhedged, but hedge the difference between your actual stocks and the typical stock requirements.

Hope this answers your question.

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Thanks Fat Tails, I do trade crack spreads and watching the market closely on that.

I was wondering how you benefit from owning physical oil (first, regardless Im refinery or not and then try to see if I can apply anything). Im interested in Brent, its in backwardation, no contango in near term futures.

When you simply shorting frontline and taking long down the curve you playing on curve flattening. How adding physical adds value?

Let say I have physical 10K bbl of Brent oil bought by $125/bbl.
· If I store the oil till apr 14th (cost of carry – convenience yield) I will have $124/bbl
· Frontline future (May 12) trades at 125 - short the future
· Lock in $1/bbl pl

Why should I go long further down the curve? If I can lock in profit by using frontline.

Appreciate your comments.

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Maxa View Post
Thanks Fat Tails, I do trade crack spreads and watching the market closely on that.

I was wondering how you benefit from owning physical oil (first, regardless Im refinery or not and then try to see if I can apply anything). Im interested in Brent, its in backwardation, no contango in near term futures.

When you simply shorting frontline and taking long down the curve you playing on curve flattening. How adding physical adds value?

Let say I have physical 10K bbl of Brent oil bought by $125/bbl.
· If I store the oil till apr 14th (cost of carry – convenience yield) I will have $124/bbl
· Frontline future (May 12) trades at 125 - short the future
· Lock in $1/bbl pl

Why should I go long further down the curve? If I can lock in profit by using frontline.

Appreciate your comments.



During a contango market, you can use physical oil for arbitrage. This requires accessible storage capacity. Buy the oil, sell the futures short and lock in the profit. If Brent crude is in normal backwardation, you do not want to own it, but would try to sell it to the spot market. Backwardation points to a physical shortage.

During a backwardation market, you would want to sell as much physical oil as you can to purchase it back as a discount. However, selling physical oil is only possible, if you own it and if you don't need it for securing your own supplies. If you have bought 10K bbl physical oil, you should get rid of it immediately.

Let us assume that you have bought physical Brent for $ 125 and have sold short the equivalent of futures (May 2012 contract) at $ 125. Then you can exchange your physical position for a long futures position at settlement. If you do this, you will have to pay interest to your bank for financing the physical position and storage fees to the operator of the tank farm. And in the end you will have accumulated a fat loss.

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