Chances for option writers in the gasoline market

Hurican Harvey which hit the U.S. caused a price rally in gasoline. This creates a chance for option sellers to look at selling call options. However, this trade is only for experienced trader and I will explain why.

Beginning traders or investors, don’t look away. The example of gasoline is a great illustration how the market tends to overreact when something unexpected occurs.

Back to options. Options always depend from the underlying asset. Therefore, let’s first have a look at the gasoline futures (even though my aim is to sell call options on gasoline futures, not the futures themselves). If you are not familiar with options, check out the “OPTIONLAND” part of this website.

GasolinGasoline pumpse futures are traded at the New York Mercantile Exchange (NYMEX) which is owned by the CME Group. The symbol for gasoline is “RB”. The symbol helps us to find the relevant futures contract or the relevant option in the trading account. Gasoline belongs to the “Energies” because of its use as fuel. One future contract includes 42.000 gallons of gasoline which is almost 160.000 liters. This would be enough to fill the tanks of about 2.600 cars. That is why, we do not want to receive any physical delivery of gasoline.  Futures contract on gasoline are traded for every month, but in later dates, there are less and less contracts traded.

Why we focus exactly on gasoline – Fundamental analysis

The main fundamental data having major impact on gasoline prices in the last weeks can be described by two words: “Hurricane Harvey”. Hurricane Harvey hit the U.S. and so the refineries in the state of Texas that remained closed and could not produce gasoline. This resulted in an explosion of the gasoline price as there are concerns that the current supply cannot meet the current demand.
The September contract (which expired the last day in August) has experienced the greatest increase in price. Contracts for the following months increased in price significantly as well.

Price chart of gasoline
October gasoline futures contract showing the price increase caused by the Hurricane Harvey

Actually, the gasoline contracts are currently in backwardation. This is an unusual situation, but it expresses exactly what is happening right now. Backwardation means that the earliest contract (for October) is the most expensive contract. The November contract is a little bit less expensive etc. The reason for this is that everybody wants to have gasoline right now. There are concerns about a shortage of supply. Subsequently, this pushes the price up.

In a normal situation, storable commodities act exactly the other way around. If you buy a commodity at a later date in the future, you pay more because you have to consider various costs. The commodity has to be stored somewhere, it has to be insured against any damage etc. These costs (referred to as “cost of carry”) cause that in general, gasoline delivered in October would be a little bit cheaper than gasoline delivered in November. The November contract would be a little bit cheaper than the December one and so on.

Price of gasoline in different months
The first column (from the left) shows the October gasoline contract traded for 1.75. The next gasoline contract (November), represented by the second column from the left costs just 1.6 etc.

We know what caused the spike in prices and that is a good starting point.

What else is important to consider?

The refineries producing gasoline as well as heating oil from crude oil will very likely begin soon with the production. More importantly, the refineries are able to adapt their facilities to increase the production of gasoline over heating oil so as to meet the current high demand.

Another fact to consider is that in the summer months, the demand for gasoline is high because of the summer holidays. People travel more than usual and so the usage of gasoline as fuel increases. Seasonally, the prices of gasoline begin to decline as of September after the summer months in the northern hemisphere are over.

Seasonal chart of gasoline
Seasonal chart of gasoline showing decline in price after the summer period

Hence, after knowing this, would you bet on further increase in prices for gasoline or would you bet that the prices will not increase as much, after the temporary shortage of supply is over? If one sells a call option, the price of gasoline does not have to fall in order to make a profit. It is enough when the price does not increase rapidly anymore, but it can stay the same, decrease or even slightly increase (not too much).

The next advantages of selling options on gasoline is the current high implied volatility resulting from the price explosion. High implied volatility is always good for an option seller because it means, in basic words, the options are expensive. If you sell options, you receive a good premium.

Up until know, the trade in gasoline looks ideal. Why did I mention at the beginning that this trade is only for experienced option sellers?

There is one considerable disadvantage when trading gasoline. It is not a liquid market. That means that the difference between the ask price and bid price (so called “spread”) is large. In addition, if the market acted differently than you expected and there would be another price explosion, the spread would be even larger. Then, it might be really difficult to close the losing position. This might result in considerable losses.

In general, illiquid markets are always to our disadvantage. As the volumes are really low, it is also very difficult to “repair” a trade by rolling the option. (“Rolling” an option is a technique how to adjust a losing trade to considerably limit the loss. If it is of your interest, I might write about that later on this blog.)

Summary:

In my opinion, there is a good chance to sell call options on gasoline futures. However, the gasoline market is not liquid. Because of this reason, I am thinking whether to enter the trade. I will follow this market very closely and look for opportunities to sell a call option in the November gasoline contract, deep out-of-the money. This means that I would eventually sell a call option with the assumption that the price of gasoline will not reach a certain price level which is above the current price.
Let me know what do you think about this trade and how would you use the situation in the gasoline market?

INTERESTING FACT:
Usually, crude oil and gasoline prices act very similarly (they have high positive correlation), but in this particular case, they rather went into opposite directions. The reason is that the refineries producing gasoline closed. Hence, the supply might not meet the demand. However, the same refineries use crude oil to produce gasoline. As they are closed, the demand for crude oil is lower resulting in falling prices.



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