Calendar Spread options, or CSOs, are options on the spread between two futures contract months, rather than a single underlying contract month.
Unlike vanilla options that give the holder the right to enter a long or short futures position, calendar spread options exercise into two separate futures positions: one long and one short.
For example, a Natural Gas option derives it price and potentially exercises into a Natural Gas futures contract. Whereas, a Natural Gas calendar spread option derives its price from the price differential between two Natural Gas futures contract months.
The Natural Gas term structure is defined by seasonality. The withdrawal season, thought of as winter, ranges from November to March and is noted for its volatility. The injection season, referred to as summer, ranges from April to October and is generally less volatile.
During the winter season, gas consumption peaks because of increased heating demand from residential, commercial and industrial end-users.
During the summer season, gas demand decreases while production continues, resulting in excess natural gas to can be stored. Because of unpredictable winter demand, the winter Natural Gas futures typically trade at a premium to the summer futures.
Calendar Spread Options provide a leveraged means of hedging against, or capitalizing on, a change in the shape of the futures term structure.
A call option can be exercised into a long futures position that is closest to expiration and a short futures position in a more distant month. The put option can be exercised into a short futures position that is closest to expiration and a long futures position in a more distant month. The strike price is the price differential between the long and short futures positions.
A trader is expecting a colder-than-normal winter and is bullish on the March/April spread, expecting March futures prices to trend much higher relative to April futures prices.
On December 1, the March/April spread is trading at a differential of 20 cents with March at $3.10 and April at $2.90.
The trader believes the March/April spread will settle higher than $1 when it expires at the end of February. The trader purchases a CSO call on the March/April spread at a strike price of 65 cents at a cost of 13 cents.
In order to break even, the March/April spread must reach at least seventy-eight cents upon expiration.
Purchasing a call limits the trader’s downside risk versus going long the futures spread. The maximum loss on the CSO is the premium paid, 13 cents, where the maximum loss on a futures position can be much greater.
At March futures expiration, the March/April spread settles at 1.10: March at 4.20 and April at 3.10.
The trader’s bullish sentiment was correct – and his CSO call settled in-the-money by 45 cents, netting a profit of 32 cents.
Traditionally, market quotes on CSOs were obtained through a broker or chat system. Now, market participants can transact CSOs through electronic trading platforms, like CME Direct.
A Request for Quote (RFQ) is created by a market participant by selecting the option instrument or option spread instruments. An RFQ allows the submitter to anonymously gauge the market for price and size for an instrument or strategy. After the RFQ has been processed by CME Globex, the Request for Quote and any associated market price and size is disseminated to the marketplace.
Traders can then execute based on those prices or counter with their own price. Or they can do nothing at all - because there is no obligation to trade on a submitted RFQ.
Oil and gas prices are highly elastic with respect to various fundamental factors including weather, geopolitical risk and unanticipated supply and demand. Unpredictable changes from any of these factors can have an impact on forward curve prices and the correlation between the calendar months.
Calendar spread options provide a leveraged means of hedging against or capitalizing on, a change in the shape of the futures term structure. CME Group has a diverse product offering of Calendar Spread Options across Crude Oil, Natural Gas and Refined Products.