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by Brynne Kelly

May 12, 2017

Just like the delicate balance between a strong versus weak currency, oil prices between OECD and non-OECD regions need to strike a balance.  US Exports to Non-OECD regions will be the key to balancing growing US production versus slowing US demand growth:

Since the last OPEC cuts were announced, WTI crude oil has gone from trading at a $2.50 premium to the OPEC basket price to discounts of up to $2.00 (see Figure 1).  With the export ban lifted, the US is now positioned to take advantage of a weak relative ‘currency’ (oil price) by moving US production to more expensive global markets.

 

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Figure 1.  Prices before vs after OPEC cuts

This is certainly the dilemma that OPEC faces going forward, starting with the upcoming May 25 meeting.  OPEC used to be the Gold Standard to which world oil prices were pegged.  As in 1971 when the world moved off the gold standard, so too is the world now slowly moving off the ‘OPEC-Standard’.  The shifting of the supply/demand picture between regions is forcing producing nations into ‘currency’ (oil price) wars.  At this point in the game, OPEC production cuts only strengthen their relative ‘currency’ (oil) in the short-term making ‘currencies’ (oil) from other countries more attractive to buyers.  The path to outright price inflation is becoming less clear.

The move in spread relationships among the various futures curves this past week (Figure 2 below) highlights the uncertainty in relative prices as the market awaits the upcoming OPEC meeting.   Will production in the US continue to find a home in growing global markets or will production from other countries be more price-competitive?  Notice that the back-end of the WTI and Brent curves gained relative strength to their Oman counterpart in the Middle-East and are actually up week over week.

Figure 2.  12 month futures price relationships

Is this an anomaly or a lack of confidence that US exports are viable at these levels?  For now, the price ‘wars’ will continue to search for a balance.

Inventories:

Weekly EIA Inventory figures posted a net Draw of 7.5 for the week ending May 5, 2017 (Figure 3).  The market finally got its much-anticipated draw in gasoline inventories of (0.40).

Figure 3.  Weekly EIA Inventory Statistics

EIA Inventory

To provide context, Figure 4 takes a look at inventory changes for this week over the past 3 years.

Figure 4.  Comparison of this week’s inventory change to prior years

With total inventory levels still at the top end of the historical range, it will take a lot more than this one week’s draw to change the overall picture.  If we simply take the average summer inventory draws over the past 3 year, September-end total inventory levels still look historically high:

Figure 4.  Comparison of this week’s inventory change to prior years

2017 end of summer crude oil inventory projection

Bottom-line, inventory statistics still aren’t providing a catalyst to break us out of the $45-$55 range.

What do Futures Curves tell us?

Crude oil futures prices for the balance of 2017 fell just under 1.0% this week and were essentially unchanged in the gasoline and distillates.  While gasoline cracks continued to hold their ground, Ultra Low Sulfur Diesel(ULSD)/Heating oil cracks also found a bit of a bottom.

In-line with things outside of the US gaining relative value, note that it was the non-US ULSD cracks that moved higher relative to their local crude oil market.  This makes sense given relative overall demand growth ‘US versus non-US’.  As WTI is the least expensive of the 3 benchmarks right now, US refiners are the winner in the product markets.

These relationships are helping move oil through the ‘system’.  The question is how much price incentive OPEC is willing to provide to non-OPEC producing nations.

With the next OPEC meeting 2 weeks away, markets appear relatively ‘status quo’ rather than ‘bracing for impact.’

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Read More Brynne Kelly Research

Is a Rotation Out of Oil Into Equities Underway?

Putting Gasoline Inventory Build Into Perspective

Crude Oil Market Not Willing to Pay for Storage

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by Brynne Kelly

[email protected]

May 5, 2017

Rotation from Oil to Equities??

As the upside picture for crude prices is called in to question in light of the deteriorating supply/demand picture, ‘capital’ may be moving to markets with greater upside potential. Could that be what we are seeing in the chart divergence above?

Equities aren’t the only market holding relative value this week.   Crude Oil is losing ground everywhere you look.

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WTI versus Natural Gas

While there is no real direct correlation between WTI and Henry Hub, they are both part of the ‘energy complex’ and you can see below that the ‘spread’ is now lower than it was at this time last year.

WTI versus NGL’s

In addition, the NGL components, that are often considered to follow the price of oil, fell a combined 2.33% for the June contract compared to WTI’s 8.26% decline for the same period.

WTI versus Gasoline

Even the front months of the gasoline crack held steady amidst the continued slide in petroleum prices during the May 4 trading session.

So the question is:  Will oil pull the above-mentioned markets lower, are they signaling a bottom or is oil on a path of its own?

This week’s EIA statistics

Weekly Oil Inventories showed a net DRAW of 2.7 for the week ending April 28, 2017; Crude draw overshadowed by a slight BUILD of .2 in Gasoline stocks (see detailed stats in Figure 1)

This week’s gasoline build of .2 brings the 4 week total to a build of 2.1.

How the 1 and 4 week-cumulative inventory changes stack up

Looking at the EIA report (below) of total gasoline supplied alone, nothing stands out.  However, the conclusion of the market is that due to the builds in gasoline the demand-side of the equation is where the problem lies.

Which is exactly what we see in the weekly US Gasoline demand stats (below)

This reminds me of natural gas inventories heading into the winter season. Everyone is full of anticipation waiting for the demand (weather) to show up to use all of the production that has been stored away.  If the weather doesn’t show up, the market moves on and focuses on the next demand season.

If we don’t see the gasoline demand materialize, a similar thing will happen in the oil complex.  The market will move on from “driving” season to the next demand season, which in this case is heating (heating oil) season.

Perhaps they already are.  You can see below that the heating oil cracks sold off more this past week than gasoline cracks did.

 

Crude Oil Prices and Spreads

There was a mixed bag when it came to the crude oil spreads (arbs) this week.  Both the Brent/WTI and Brent/LLS spreads fell slightly versus last week in the front of the curve, but actually increased over last week in the back of the curve.  That was not the case for the Brent/Dubai spreads in which the entire spread curve shifted lower.

 

Demand-willing, the spreads still favor US crude oil moving towards Europe and Asia.  The tighter Brent/Dubai spread also increases the competitiveness of North Sea crude against Middle Eastern grades, meaning we should see a widening of the Brent/WTI spread.   Any increase in shipping rates at this point would throw a wrench in all of these movements.

Crude oil prices (Figure 2 below) fell an average of 3.2% since last week’s report with gasoline prices down another 4.6% and distillates down 7.3% (Figure 3 below).  The Dec7/Dec8 spread held on to its slight backwardation in oil with the Jun7/Dec7 spread contango widening by $0.14, not a ringing endorsement for short-term oversupply. Rather, it points to a general expectation of current conditions to persist throughout the rest of the year.

 

 

 

 

 

 

 

 

 

 

 

 

 

Due to seasonality, the Jun7/Dec7 in gasoline is almost $7.00 backwardated while The same spread in heating oil is $1.20 in contango.

This, unfortunately, will incent refiners towards gasoline production in the short term since it carries the highest premium to crude oil prices in the market.

Comparing this week’s production and inventory levels to the same week in 2016, 2015 and 2014, the percentage change in US oil prices are certainly reacting negatively by varying magnitudes to the percentage that current inventories exceed those in prior years.  Keep an eye on these year over year percentages going forward.

 

What to look for in the coming week:

  • Entry point into any of the ‘one-off’ spreads (ES/WTI, NG/WTI, NGL/WTI) mentioned above if you believe they will revert to the mean.
  • RB and HO cracks.  Front month gas cracks are at 4 year lows  for this time of year, but if demand doesn’t materialize relative to supply, refining margins will have to get ‘punitive’.

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More Brynne Kelly Awesomeness…

Putting Gasoline Inventory Build Into Perspective

Crude Oil Market Not Willing to Pay for Storage

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by Brynne Kelly

April 28, 2017

Weekly Oil Inventories showed a net BUILD of 1.7 for the week ending April 21, 2017; Crude draw overshadowed by a BUILD of 5.9 in Gasoline and Distillate stocks combined:

This week’s gasoline build of 3.3 flips the 3 week total to a net build of 1.9 as seen below making for a dismal comparison to the same 3 weeks in 2015 and 2016 (see detailed stats in Figure 1).

The Fundamentals:

While the 3 week changes are more reflective of the end of refining maintenance season when crude oil inventories begin to draw down and product inventories increase, the continued build of gasoline is the bottleneck and a point of contention for a balanced market.  Until there is evidence of increased demand drawing down this inventory, gasoline cracks will be under pressure.  The refining incentive to produce gasoline has been high and will continue to favor gasoline unless near-term spreads retreat.

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The term structure of RBOB gasoline crack futures week over week reflects the pressure on near-term margins:

RBOB, Curve Shift, RBOB Crack Spread, Refining Margin

The shape of the curve also represents the seasonality of gasoline demand and refinery outages.  If stocks continue to build at current rates, we should expect the front month cracks to shift lower until production responds.  Watch the June7/June8 RBOB crack spread which moved from $0.50 backwardation last week to almost $0.70 contango this week.

Compare the EIA chart below to the shape of RBOB futures curve. Historically, gasoline inventories tend to level off or decline at a slower pace during the summer until building again towards the end of the year.  To date, we are sitting at the top of historical 5 year ranges.

EIA historical gasoline inventories, EIA inventory projections, Distillate Inventory

Gasoline build, Distillate Build, Inventory glut

Prices across the Petroleum complex fell another 2.5% week/week in response to Inventory report:

What’s most notable this week is the relative shift in US prices (LLS and WTI) versus European and Mid-East prices (Brent and Oman (see Figure 3 for detailed price curves).

WTI, Brent, OMAN, USGC Sour, LLS, WTI Oman spread, LLS Brent Spread

Bottom-line, incremental demand for US crude will come from Asia and the Middle East.  Like all refiners, they are interested in the most competitively priced grade of crude oil.  There won’t be a massive outpouring of US crude oil from the Gulf Coast unless price spreads support it.  We have seen an expansion of pipeline and export infrastructure into and around the Houston/Corpus Christie area to enable export demand.  Since the majority of USGC refineries are still consumers of medium to heavy sour crude oil, finding a home for US light shale oil is key.  Any relative weakness of US prices can be viewed as a competitive advantage. 

Speaking of competitive advantages, the much-anticipated Dakota Access Pipeline is scheduled to begin operations in May.  This offers an alternative to oil transported by rail out of the Bakken area.  Rail transport costs to the Gulf Coast average between $7.50-$11.00.  Transport rates on the new pipeline are  in the $5.50-$7.50 range depending on service level.  This basically cuts the delivered price of Bakken oil into the USGC by an average of $2.00 and makes it more profitable to move barrels south versus by rail to the East Coast.  Now it’s just up to spreads like LLS/Brent to provide the export economics.

The OPEC cuts at the beginning of this year were focused on sour grades, which have since garnered a premium to lighter, sweeter grades.  This is forcing the hand of refiners around the world (including in the USGC) to enhance their ability to process the cheaper, lighter oil grades.  These type of changes take time, but speak volumes regarding economics.  If light, sweet shale is here to stay and OPEC cuts have made heavier crude grades more expensive, the long-term impact could be that refiners will shift their operational capability in favor of lighter oil.  We know that Japanese and other Asian refineries have been testing their capability to refine US shale oil in anticipation of a cheaper supply source.

With all the talk of growing US crude oil production, it’s easy to lose sight of OPEC cuts versus US growth.  As of the last production figures, OPEC production cuts have been greater than US production increases.

OPEC cuts, US production

This is why the May OPEC meeting is important.  Will they continue to limit production of the heavier crude grades that current refining capacity craves at the expense of impacting a long-term shift in refining preference for cheaper, light shale oil?

Crude oil futures, weekly price change, LLS WTI spread, USGC Sour Crude oil, Brent Dubai spread, Dubai futures

Refined product prices also took a hit this week.

The build in gasoline inventories led to a decline of 7.5% this week of gasoline cracks while the blended gasoline and heating oil 3:2:1 crack spread fell a bit less at 6.7% (See Figure 4).  Any relative increase in distillate demand could help support overall refining margins and take the pressure off of gasoline production.

Another component of the summer gasoline season is ethanol blending.  So far, the selloff in crude oil and gasoline prices haven’t translated to ethanol prices:

Ethanol futures, ethanol blending, rbob futures

With 2017 blending mandates already in place, the ratio of ethanol to gasoline prices is a dynamic to keep an eye on.  This past week, we saw the ratio move above 1.0 in parts of the term strip meaning ethanol prices are higher than gasoline prices.

ethanol vs rbob

 

Week Ahead – Expectations and Wild Cards:

As noted above, the key items to watch in the upcoming week are:

  • US term structure vs Europe and Asia and the LLS/Brent spread
  • Gasoline Demand and the crack spread term structure
  • Distillate margins
  • Discussions surrounding the May OPEC meeting.

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By Jason Pearce

If You Can’t Beat ‘Em…

In the first post on Profiting From Failure, we discussed how one of the first classic charting patterns that traders learn about – double tops and double bottoms- often fail to materialize like the trading books and blogs tell us they will.  Markets often surpass prior highs and lows, picking off the stop orders of those playing for a reversal.  So much for the easy money that we were all promised…

Furthermore, I noted that the alternative to double tops and bottoms – the breakout move- can go awry as well.  Traders place stop orders to buy a breakout above a previous high or sell a breakdown below a prior low, only to see the market run out of gas soon after and reverse sharply.

It’s easy to take that sort of behavior personally.  Betting on a reversal off the highs/lows didn’t work and betting on a breakout from the highs/lows didn’t work either!  Damned if you do, damned if you don’t.  Can anyone actually win at this game?

It’s important to keep in mind that the markets don’t know who you are.  They’re like the waves in the ocean; they don’t care if you’re having the time of your life and spending all day out there surfing or if you’re getting battered by the waves and on the verge of drowning.  The waves will do what they’re gonna do.  It’s your response and interaction with the waves that will determine your personal outcome.  It’s the exact same thing in the markets.

The fact that these classic pattern failures occur often is good news for traders with the right perspective.  Instead of simply avoiding these patterns, a trader can potentially profit by trading off the failure of these patterns.

We have dubbed these classic chart pattern failures the Wash & Rinse pattern.  Quite simply, when a market surpasses a prior high or low, the trader looks to get positioned if and when the market reverses back in the other direction.  These reversals are often the start of a tradable trend reversal.  I showed you several examples of this pattern at work in the prior post.

All in the Details

Let’s say that you see a market clip a prior high or crack a prior low.  It then runs all the stop orders.  Then shortly after that, the market it starts to reverse.  You might just have yourself a real live Wash & Rinse pattern trade in the making.  It’s a trading opportunity!

Now comes the tricky part: Where do you get in the market when it reverses course?

There are multiple answers that can apply here.  A trader can use an intraday trade back under the old high to get short.  Or for additional confirmation, he might wait for a close back under the old high to get a bona-fide sell signal.

Perhaps one would want to see a trade below the low of the bar where the breakout occurred before getting involved.  This would better negate the breakout and give you the greenlight to get short.

If you want to smooth things out a bit more, you can also apply these ideas to the weekly bar chart instead of the daily bar chart.  Your probabilities of success on the weekly timeframe might increase.  But the tradeoff is that waiting for the weekly bar signal might get you in later and at a much worse price than the daily bar signal.

Here’s one more idea to explore: Set a price band around the old high that the market is pivoting off of and wait for the market to trade back under price band (above the price band if it’s a trade on the long side) before getting in.  The price band could be a derivative of the Average True Range (ATR) to account for the market’s volatility.

These are just a few ideas that a trader can use to initiate a trade off a Wash & Rinse pattern.  I’m sure there are plenty of other ways for you to throw your hat in the ring.  I urge you to roll up your sleeves and do some deeper research on your own.  Discover what sort of parameters and triggers work best for your own trading style.  Then you can make this trading pattern one of your own weapons of choice.

Charting the Futures

Since futures contracts are always expiring and being replaced by the next delivery contract, it presents a unique charting wrinkle that does not occur with stocks, ETFs, and cash currencies.

Most longer-term futures charts are created by splicing together the prices of the closest-delivery contracts and rolling them over based on either the expiration of the nearest contract or a change in leadership where the trading volume and/or open interest in the nearest delivery shifts to the next delivery contract.

Due to carry-charges, interest rates, seasonal pricings, price squeezes, etc. the futures prices can sometimes vary noticeably from one delivery contract to the next.  So the rollover on the long-term charts can potentially create a chart pattern –like a Wash & Rinse pattern– that does not necessarily occur on the specific delivery contract being traded.

From my experience, this has not really been an issue.  The pattern still holds up.

But for traders who are concerned that it may be problematic, a filter could be added to the Wash & Rinse pattern by making sure the price on the specific delivery contract that they are trading is in agreement with the Wash & Rinse pattern that they are seeing on the larger timeframe.  Something simple, like a trend line break, a moving average crossover, a breakout signal, etc. should do the job.

Failure of a Failure

Question: What should a trader do if a Wash & Rinse pattern fails and the market hits new highs for the move (or lows for the move in a downtrend)?

Answer: Get out!

It is important to keep in mind that this pattern does not work every time.  Nothing does.  Sometimes you win, sometimes you lose.  The trick is to minimize the damage when you lose and exploit the opportunity when you win.

As far as losing goes, you should immediately place protective stop orders as soon as you get into a trade position.  The protective stops are set to liquidate your position automatically if there’s a reversal.

Logically, a new high after initiating a short position or a new low after initiating a long position means you are wrong.  You need to abandon the trade ASAP.  Even the Top Gun pilots use the ejection seat when the situation calls for it.

But Wait, There’s More!

Here’s a bonus second answer to the above question: If you have the stomach for it, you can even get positioned back in the direction of the initial breakout.

The Wash & Rinse pattern is a pattern based off of a failure of another pattern.  Yet, there are times that this failure pattern will also fail!  Hey, nobody ever promised that trading is easy…

Sometimes a market will breakout, experience a pullback that knocks out the weak-handed players and triggers the Wash & Rinse pattern, and then turn right back around to continue on with the initial breakout move.

This means the Wash & Rinse pattern didn’t work.  It also means that the initial breakout, while initially sloppy, is still in effect.  There’s still plenty of demand for the market so the path of least resistance remains in the direction of the initial breakout.  If you are going to get back on this horse, you better be going in the same direction that it’s running.

As an added benefit of the second breakout attempt, the reaction low of the pullback that immediately precedes it creates an obvious line in the sand for strong near-term support.  Placing sell stop orders below this level provides you with a logical bailout point and defines your risk on the trade.

Current Market Setups

One you have a grasp on how the Wash & Rinse pattern works and you have worked out the details for your own entry and exit criteria, it’s time to take it for a test drive.

You can do this by ‘paper trading’ the markets as they unfold.  It’s important to keep honest records.  That’s the only way that you can make real progress.

Now, if you really want to shorten the learning curve and make the emotional connection that comes from having real money on the line, you can do trade these in real-time with small positions.

In the prior post, we showed several examples of how some Wash & Rinse trades played out.  Now we’ll take a look at a few markets that have recently staged a breakout or are getting close enough to prior highs/lows to warrant attention.  Put these on your watch list as they have the potential to turn into Wash & Rinse pattern trades.

In mid-February, the ETF for the Brazil Index (EWZ) closed above the 2016 high of $38.50.  The following week, it closed back below the 2016 high and a Wash & Rinse pattern went into effect.

After bouncing off the March low, EWZ tagged the 2016 high again.  It reversed sharply before the day was over.  This keeps the Wash & Rinse pattern in play.

Aflac (AFL) set a record high at $74.50 late last summer.  It was actually made by way of a Wash & Rinse sell signal off the daily chart high that was set six weeks prior.

This week, the stock surpassed the August 31, 2016 and posted a new record.  Initially, this is very bullish.  But keep a close eye on it.  A failed breakout attempt up here could pave the way for another short sale opportunity in AFL.

Back in February, Continental Building Products (CBPX) surpassed the 2016 high of $24.78.  The stock advanced for a few more weeks, indicating a legitimate breakout.

At the end of March, however, CBPX closed back under the 2016 top.  This negated the breakout and triggered a sell signal as per the Wash & Rinse pattern.  Since the stock is still just a stone’s throw from the 2016 pivot price, traders still have opportunity to get short.

Genesco (GCO) traded a little over two dollars away from the September 2016 multi-month low of $47.66.  This level marked the start of a three-month advance that boosted the stock by 51%.  Watch this stock carefully to see what transpires.

Moody’s Corp (MCO) topped at a record high of $113.87 in the summer of 2015 and then surrendered nearly one-third of its value over the following six and a half months.

The stock finally recovered and blasted to a new high just last week.  The fun continues this week with another gap higher.  But should it fail to continue its trek, you’ll have a Wash & Rinse sell signal in the works.

Revlon (REV) has been in a nosedive since the start of March.  It is fast approaching the January 2016 low of $24.20, which was the lowest traded price in nearly two years.

As you know by now, a drop below the 2016 low, followed by a reversal higher, would be a Wash & Rinse buy signal.

It appears that Regis Corp (RGS) is reaching a do-or-die level.  The stock is right on the doorstep of the September 2015 multi-year low of $10.60.  After that, the last stop is the 2008 Financial Crisis low of $8.21.

 

Although this stock currently looks like a dumpster fire you should stay away from, a Wash & Rinse pattern might still give you a technical reason to take a shot at the long side.  The last time it traded down here, a 71% rally followed in just nine weeks.

If you want to see a stock that has bucked the trend of the bull market, you need to look no further than Twitter (TWTR).  This one has been a complete train wreck.

As traders, though, we are not looking for a company to buy.  We are looking for a setup to pull some money out of the markets.

The record low for TWTR was set at $13.72 on May 24, 2016.  The stock dropped as low as $14.12 this week.  It’s getting close.

Don’t forget that TWTR rallied as much as 85% off the lows last year and it only took a little over three months.  Should the 2016 low get breached, followed by a reversal, a Wash & Rinse buy signal might be worth trading.

The recent drop in industrial metals has hit the stock prices of the producers pretty hard.  Olympic Steel (ZEUS) is one of those companies currently feeling the pain.

ZEUS bottomed out with the main market during the Presidential election.  The low of the correction was established at $17.14 on November 8th.

ZEUS recently cracked the November low and traded to a new one-year low.  The correction could continue, of course.  However, a reversal from here could create a Wash & Rinse buy signal.

The currency markets seem to be in limbo.  On the one hand, the late 2016 breakout to new multi-year highs in the US dollar index and new multi-year lows in the Euro currency stalled out and triggered Wash & Rinse pattern signals right after 2017 began.

On the other hand, there has not been any follow through on the reversal patterns.  The greenback and the Euro are just a stone’s throw from the multi-year levels that were posted during the first week of 2017.

Theoretically, the currencies could decide to stay range-bound at these multi-year levels for the rest of the year.  In reality, however, they are worth monitoring on the weekly and monthly timeframes to see which way things will resolve.

Changes in economic data trends, stock market corrections, Tweets from the Commander In Chief, further rate hikes and/or changes in the expectations of further rate hike expectations, etc. all have the potential to be catalysts for the next move in forex.  Currencies are currently a slow moving train, but they may be one worth boarding soon.

Speaking of rates, take a look at Ishares 20-Year Bond (TLT).  It triggered a small Wash & Rinse buy signal back in March when it undercut the December low of 116.80 and then immediately reversed higher.  This may have been the low of the year, so traders could consider buying pullbacks in TLT.

But

If TLT breaks down again and breaches the current low of 116.49 it will negate the Wash & Rinse pattern.  It would be a blessing in disguise as it may allow the ETF a chance at testing the June 2015 low –which also marked the low for the year- at 114.88.  A Wash & Rinse buy signal off this low would certainly be worth taking a shot at.

Deutsche Bank offers an easy way to own a basket of agricultural markets via an ETF.  Of course, “easy” doesn’t always mean “profitable”.  Anyone holding the DB Agriculture Fund (DBA) as a long-term investment has racked up losses in five of the last six years.  The +2.6% gain in 2014 offered little consolation –and very little profit- to the Buy & Hold crowd.

From a trading perspective, however, a buying opportunity may be setting up.  DBA recently clipped the February 2016 record low of $19.55.  Depending on how it unfolds from here, a Wash & Rinse buy signal could potentially materialize.

Also in the commodity sector, the cocoa futures market looks really interesting right now.  The 2011 low on the nearest-futures chart was $1,898.  Cocoa clipped this low in February and immediately bounced, triggering a Wash & Rinse buy signal.

The bounce faded and cocoa dropped back under the 2011 low.  In addition, the market traded below the February low.  This constitutes as Wash & Rinse pattern failure.  It’s a sell signal.

However, cocoa has now cracked price support at the 2008 Financial Crisis low of $1,867.  A reversal higher could trigger yet another Wash & Rinse buy signal.   If you like chocolate, watch this one carefully!


More Articles by Jason Pearce:

How to Trade with Moving Averages, Part II

How to Trade with Moving Averages, Part I

Market Returns Do Not Equal Investment Returns with Leveraged ETFs

Is The Canadian Housing Market Bad for Canadian Banks?

2017: The Death Year for Stocks

Potential Bond Market Reversal Ahead

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trading butterfly spreads

Trading Option Butterfly Strategies


Butterflies fit into the class of “non-directional” strategies. In terms of market opinion they are similar to straddles and strangles in that one is not primarily guessing a particular direction in the market, but rather the size of that movement.

• Long butterflies should be used when one is predicting little or no directional movement or a “trading range” in the underlying, and the trader seeks to profit from an increase in the value of the position due to time decay or falling implied volatility.

• Short butterflies should be used when one is predicting a large magnitude move in either direction, and the trader pursues profit from a decrease in the value of the overall position due to an increase in implied volatility or a move away from your long strikes.

Butterfly Spread Explained

The classic long butterfly consists of two longs and two shorts. Typically a long at one strike, two shorts at a strike greater than the long and then another long at a strike greater yet than your short strike. These three strikes are usually equidistant from each other and they are usually all calls or all puts in the same expiry (of course on the same underlying).

Example: Long Butterfly

IBM January 95 calls +1
IBM January 100 calls -2
IBM January 105 calls +1

This gives you, a long vertical spread and a short vertical spread.

Depending whether you sold the middle strike (the body) or sold the lowest and highest strikes (the wings), determines whether you are long the butterfly or short it. Whatever you do with the wings is what you have done with the spread. Long butterfly spreads are safer when you construct them with a lot of time left until expiry (they are usually very inexpensive) and get more expensive as one gets closer to expiry with the spread still near the money.

Since you are selling the center and buying wings, you have a chance of making a maximum of the difference between the two strikes, less your cost of the butterfly.

The most you can lose is the amount you paid for the butterfly, giving most typical butterflies a 5:1 up to a 10:1 risk/reward ratio. Expanding out to skip a strike and do butterflies with a larger span, to say 10-point butterflies, increases the cost, but also increases the range of payout and the risk/reward stays high.

I want you to think of these now, because they are a safer way to sell premium than just selling premium naked. As the volatilities climb, butterfly spreads should get “cheaper” and this is a fine time to put
some elongated butterflies or butterflies that skip strikes in the middle (called Condors) on in the May through August expirations.

The Long Butterfly


Think of a long butterfly as containing an embedded short straddle wrapped within a synthetic long strangle. This type of structure allows the properly positioned long butterfly to capitalize from time decay and/or falling implied volatility just as a short straddle would. The big difference is that the long strangle “wrap” of the long butterfly severely limits the risk in the position, making it an appealing “directionless” strategy for risk-adjusted return traders.

Butterflies are ideally suited for trading in directionless markets: The foundational reason to put on a butterfly is to target a well-defined price range within which the stock will trade at expiration.

This statement begs the question, “What is a directionless market?” A directionless, or “sideways” market is one that shows no definite or sustained direction in price movement. Although the price of the underlying may fluctuate, it tends to trade within a certain well-defined range, i.e. it doesn’t penetrate either the defined support level or the defined resistance level.

It should be noted that directionless markets are the most common markets a trader encounters; more so than either a bull or a bear market! The adept trader will develop the ability to identify such a market by recognizing when a stock is consolidating. An adept studying of charts (technical analysis) is important here

Why do we say that the long Butterfly is a “limited risk” strategy? That’s simple: if you put on a long Butterfly, you can never lose more than the initial debit paid out. The Butterfly is constituted so that it is “exposed” to losses on either side of its “body”, but this exposure is hedged by the location of the “wings”.

Why do we say that the Butterfly is a “limited reward” strategy? Well, at expiration the long Butterfly will always have a value between zero and the width between each strike price (5 points here). In other words, the price of a 5-point Butterfly will never exceed $5.

Note that the spread will be worth its maximum value if it closes right at the strike of the shorts. If this happens, the long OTM (out of the money) option as well as the two shorts will expire worthless. The long ITM (in the money) option, however, will expire worth its full value of $5. So we know that the greater the chance of it closing at the middle strike on expiration, the more expensive it will be.

Any movement away from the middle strike will cause the spread to lose value. The worst-case scenario occurs if it closes either below the lowest strike long option, or above the highest strike long option. In our example above, the call Butterfly will lose value below $100, because as stock drops below $100 the ITM 95 call will begin to lose value. The call Butterfly loses value above $105 because the loss from the two short 100 calls will be twice as much as the gain from the 95 call.

Greek Values and the Butterfly

The price of the butterfly spread becomes increasingly more sensitive to changes in the underlying with thirty days or less to go until expiration. The greeks of the butterfly respond the same way, in that they can also change dramatically and exponentially with less time to expiration.

But for all of the greek values, keep in mind that the delta, gamma, theta, or vega is not of much interest if the contracts in the spread are ninety days or more away from expiration. Far away from expiration, the greek values are minor factors; they become noteworthy only when the contracts are within thirty days of expiring.

Option Butterfly Spreads & Delta

For a long butterfly, such as the $150/$155/$160 spread in the example, the delta will be as follows:

• Positive when the underlying share price falls below the inside strike price ($155)
• Neutral when it matches the inside strike price
• Negative when it climbs above the inside strike price

The butterfly reaches its greatest value when the price of the underlying equals the inside strike price. Therefore, if the share price falls below the middle strike, that share price must rise for the butterfly to make money—hence the positive deltas. If the price of the underlying asset is above the middle strike price, it must fall for the butterfly to make money. That leads to a negative delta value.

Option Butterfly Spreads & Gamma

The gamma value of a long butterfly flows from positive to negative, or vice versa. When the underlying price reaches the outer strike prices of the butterfly, the gamma is positive. This shows that the butterfly would produce positive deltas if the underlying share price rises, and negative deltas if that share price falls, albeit to the extent that the underlying is close to a long strike. This matches the behavior of the delta of the long butterfly as shown in Figure 9.

Meanwhile, the gamma of the long butterfly is negative when the underlying share price matches the inside strike price (see Figure 9). This shows that the butterfly will create negative deltas if the underlying share price rises and positive deltas if the share price falls. But you want your delta to be neutral; you want the share price to match the inside strike price and stay there.

Option Butterfly Spreads & Theta

Think of theta as the opposite of gamma. If a long butterfly is negative gamma, the theta will be positive; if a short butterfly is positive gamma, it will have a negative theta. For any butterfly, the theta will be positive if the stock price approaches the inside strike price.

As the expiration date approaches, a positive theta is good for a long butterfly and bad for a short butterfly. If, however, the underlying price trades either high or low, and thus near one of the outer strike prices, the theta is positive for a short butterfly and negative for a long butterfly (see Figure 10).

That is, if the underlying price is close to one of the outer strike prices, it benefits the holder of the short butterfly, because the theta will be positive, but the theta will be negative for the long butterfly. With the short butterfly, remember, you sold the contracts with the outside strike prices (say, $60 and $50), bought two contracts with inside strike prices ($55 each), and earned a net premium in the transaction.

With a short butterfly, you make a profit if the share prices climb toward the highest strike price ($60) or fall toward the lowest strike price ($50). The short butterfly profits if the market is active, and the theta tends to reflect that.

This is an excerpt from Managing Expectations by Tony Saliba.

Tony is going to teach an Options Master Class.

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More Excerpts from Tony’s Book

What the Pro Options Traders Know About Vega

What the Pro Options Traders Know about Delta

Free Audiobook Chapter: Options Gamma

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