nicely done
The ACD Method
- Thread starter sbrowne126
- Start date
nicely done
Yes Mav, it is making sense. You get on a spread where you also get the "option" that backwardation might happen due to supply constraints and pricing structure changes.
But, if i am understanding this right, isn't there a risk of price going down and a chance of contango?
Thanks Mav!
Mav bringing his A game today, great post. How would explain "convexity" ? I see that term thrown around alot. How would you define it, thanks.
Going down? Shiiiiiiiiiiiit dawg. That ain't gonna happen.
The issue is not whether price is or can go down, it's the fact that all the "convexity" is on one side of the bet. That's point one. Point two, based on what I said earlier about the forward curve, let's say dec 2016 gas should be trading at 5.00 even. But you notice that suddenly that contract is trading down to 4.75 while the others are flat. That .25 is someone selling forward their physical production. Think of that .25 as the synthetic call. In other words, that is what you should be paying to take supply off the market at that time from a producer. But you are not paying 5.00 you are paying 4.75. The producer is paying the .25 and you are paying zero. If the whole curve shifts down by more then .25, sure you could lose some money but you are not just buying the Dec 16 gas, you selling the jan 17 gas at let's say 5.10 or 5.05. So if the whole curve shifts down .25 you are still flat in the position.
Keep in mind I'm keeping things very generic and simple here for the purpose of explanation. I'm trying to get you to see the big picture. The prices far out on the curve don't move that much so there are very different pricing dynamics at play here.
Mav bringing his A game today, great post. How would explain "convexity" ? I see that term thrown around alot. How would you define it, thanks.
Convexity refers to any non linear movement along a price curve in this example. This means there is a second derivative driving price, not first. For example y=x^2 is the 2nd derivative to y=2x.
Plug in values for x and graph it.
y=2x
--------
x=1 y=2
x=2 y=4
x=3 y=6
You get a straight line
y=x^2
----------
x=1 y=1
x=2 y=4
x=3 y=9
x=4 y=16
Now you get an ever increasing slope (this is your convexity)
But notice what happens when you have really small numbers, the loss is very minimal. It's only when you get higher x values where you start to see an increase in volatility. Hence the "option like" structure. If you are long a call for .20 and the market goes against you, you really are not losing that much. Sure at first you are down a nickel or dime but as price keeps moving away from you, your call value is not moving anymore. But when price moves in your favor, you go from nickels to dimes to quarters to dollars.
THIS is the benefit of the convexity.
And why one might perhaps prefer soft deltas to hard deltas?
I recall you saying you prefer DITM options, but FOTM will give better returns for a significant favourable move in the UL because of the convexity, correct?
Thanks, very informative. I didn't realize there are so many other trading instruments that don't get retail exposure.
Going down? Shiiiiiiiiiiiit dawg. That ain't gonna happen.
The issue is not whether price is or can go down, it's the fact that all the "convexity" is on one side of the bet. That's point one. Point two, based on what I said earlier about the forward curve, let's say dec 2016 gas should be trading at 5.00 even. But you notice that suddenly that contract is trading down to 4.75 while the others are flat. That .25 is someone selling forward their physical production. Think of that .25 as the synthetic call. In other words, that is what you should be paying to take supply off the market at that time from a producer. But you are not paying 5.00 you are paying 4.75. The producer is paying the .25 and you are paying zero. If the whole curve shifts down by more then .25, sure you could lose some money but you are not just buying the Dec 16 gas, you selling the jan 17 gas at let's say 5.10 or 5.05. So if the whole curve shifts down .25 you are still flat in the position.
Keep in mind I'm keeping things very generic and simple here for the purpose of explanation. I'm trying to get you to see the big picture. The prices far out on the curve don't move that much so there are very different pricing dynamics at play here.
What if the Jan 17 contract rises up by 0.25 while the Dec 16 remains at an even 5. Would that also result in the same cheap or free option? Because, i heard Mark Fisher saying that because of the price action in NG this year, people will be afraid that they have not hedged their NG price risk. So this could lead to rise in futures contracts of Jan, Feb.. which could result in, for example, the Dec/Jan spread going down.
Well, ideally you don't want to be short a peak month unless prices are favorable to do so. The example I gave was for simplicity purposes. Contangos are hard to sustain in gas because you give the incentive for a physical player to just come in and buy Jan, store the gas and sell it in Feb for example and get the free money. Most physical shops will jump all over that, that's free money. The squeezes happen on the delivery month not on the deferreds because of the economics of the situation. Also, as I said before, the idea is to capture these spreads at price points where the producer has the incentive to deliver the forward gas. There are a lot of moving parts here. This is not a red light/green light move to Maui trade. LOL. I'm just trying to go over the basic principles. At the end of the day,this is not a market where people are "investing" in something. Gas is being produced, stored, delivered and ultimately used. The producer is setting the price when he has supply. When he does not have supply, the end user (in most cases the LDC 'utility') sets the price and they are usually price takers in that situation.