Overview
At Dare we trade exclusively in derivative products. Derivative products track the price of the underlying asset, in this case oil, and are bought and sold as hedging mechanisms for consumers and producers of physical oil. Ultimately, we never need to consider the logistics of shipping, storing, or handling the physical asset itself which massively simplifies the operations of a commodity trading house. The two main derivatives traded at Dare are swaps and cash-settled futures.
Futures and Swaps
Futures
A futures contract is a standardised forward contract which the parties initially agree to buy and sell an asset for a price agreed upon today (the forward price) with delivery and payment occurring at a future point, the delivery date.
Futures Contracts are negotiated at futures exchanges which act as a standardised market place for buyers and sellers.
Swaps
A swap is a derivative in which two counterparties exchange cash flows of one party’s financial instrument for those of the other party's financial instrument.
A commodity swap is similar to a fixed-floating interest rate swap. The difference is that an interest rate swap the floating leg is based on standard rates such as LIBOR, EURIBOR etc. but in a commodity swap the floating leg is based on the settlement price of the underlying commodity like oil.
Swaps are typically cash-settled meaning there would be no physical delivery. The main difference between futures and swaps is how they expire.
Key Differences Between Futures and Swaps
Futures either expire with physical delivery or are cash-settled. If it is physically delivered we cover the position before expiry otherwise we would take delivery (which we do not want). If it is cash-settled we can hold until the expiry.
Unlike futures contracts, swaps are not standardized, allowing for more customizable terms. While traded futures will all be settled on the 3rd Friday of the expiration month, a swap may be terminated on whichever date the parties agree to.
Swaps expire in stages – expires as a form of decay – this means each day a part of the swap ‘prices off’. A fuel oil swap expires day-by-day until the termination date. After every settlement the swap counterparties exchange cash flows.
Flat Price, Diffs and Spreads
Flat Price
An outright position refers to having bought or sold a single product and therefore you are exposed to the risk of that single product’s price moving up or down. Flat price products refer to the outright buying of a product in a single tenor. This has zero intrinsic hedging mechanism and leaves us exposed to the full bi-directional movement of the products price.
Diffs
A diff entails the simultaneous buying and selling of two distinct yet correlated products. Diffs possess an intrinsic hedging mechanisms as the correlation of the two products in the diffs can be used hedge against outright price volatility. The diffs most commonly traded are Cracks and Arbs which will be explained in a further detail within the document.
Spreads
A spread or differential (diff) position refers to having bought/sold one product vs sold/bought another product and therefore you are exposed to the risk of the price differential of one product relative to another product moving.
Spreads, as traded at Dare, refer specifically to time spreads that involve the simultaneous sell/buying of a product across multiple tenors. Spreads come with an intrinsic hedging mechanism which makes them resistant to large spikes in volatility as only the spread between the prices in each tenor matters. There are two different types of spreads; long and short spreads.
Cracks
Cracks are a specific type of diff where refined products are bought/sold while crude products are sold/bought simultaneously. These products have very high liquidity as they are regularly sold by refineries seeking to hedge their profit margins.
Arbs
Arbs or ‘Arbitrage trades’ are diff trades between two similar products across two different markets. Arbitrage trading is a very common form of physical commodity trading where the difference in the price of a fungible product between two markets presents arbitrage i.e the potential to make profit. The Arbs we deal in regularly are referred to as follows:
Delivery Codes
A unique facet of trading derivates is how we address the month of expiry in writing. Instead of referring to the months by their name, we opt to use delivery codes that allow for a short and completely unambiguous way to reference expiry and delivery times. The delivery codes mapped to their associated months can be seen in the table. The delivery codes can then be coupled with the product code and year to give a concise record of the trade information, e.g FBRNZ23 represents a Dec 23 Brent (Fut) contract.
Front Month
Front-month, also called 'near' or 'spot' month, refers to the nearest expiration date for a futures contract. These are the most heavily traded and the most liquid futures contracts for a given commodity or futures market. Typically, the listed front month will be in the same calendar month.
Front-month prices are normally used when quoting a futures price. Additionally, the spread between the underlying security's front-month futures price and spot price will usually be the narrowest and will continue to shrink until they converge at expiration. Use of front-month contracts requires an increased level of care, since the delivery date may lapse shortly after purchase, requiring the buyer or seller to actually receive or deliver the contracted commodity.
How do futures contracts roll over?
Rolling futures contracts refers to extending the expiration or maturity of a position forward by closing the initial contract and opening a new longer-term contract for the same underlying asset at the then-current market price.
This enables a trader to maintain the same risk position beyond the initial expiration of the contract since futures contracts have finite expiration dates as opposed to stocks that trade in perpetuity (a security that has a constant stream of cash-flow). It is usually carried out shortly before the expiration of the initial contract and requires that the gain or loss on the original contract be settled by physical settlement or cash settlement.
Cash Settlement
Futures contracts have expiration dates as opposed to stocks that trade in perpetuity (a security that has a constant stream of cash-flow). Futures contracts are rolled over to a different month to avoid the costs and obligations associated with the settlement of the contracts. However, when physical delivery of an asset does not take place upon exercise or expiration, the contract is settled in cash. Futures contracts are most often settled by physical settlement or cash settlement.
Daily Settlements
Every commodity has a reporting body that determines the settlement prices each day. The main ones are:
- Platts
- Argus
- OPIS
- ICE and CME also release settlement prices for futures
Hedging vs. Speculation: What's the Difference?
Both are types of investing but the mind frame of the investors going into the trade is different.
“Speculation is to make a profit from a security's price change by betting on the direction in which an asset will be moving”. “Speculators and risk lovers” go into the trade speculating that there will be bigger returns. “Hedging attempts to reduce the amount of risk, or volatility, associated with a security's price change, by taking an offsetting position (contrary position) in a derivative, in order to balance any gains and losses to the underlying asset.
Hedgers are seen as risk-averse”, they understand that that hedge trade is for the purpose of protecting themselves should the worst happen, e.g., when paying insurance premiums in the hopes it wouldn’t need to be paid out.
Contango vs Backwardation: What's the Difference?
Contango is when the futures price is above the expected future spot price.
Backwardation is when the futures price is below the expected future spot price.
What Is an Exchange?
An exchange is a marketplace where securities, commodities, derivatives and other financial instruments are traded.
The core function of an exchange is to ensure fair and orderly trading and the efficient dissemination of price information for any securities trading on that exchange.
Exchanges give companies, governments, and other groups a platform from which to trade securities. The oil market operates through various exchanges such as:
- ICE
- NYMEX/CME
- SHFE
Product Lifecycles
At the moment of trade confirmation of the OTC trade, the trade has become legally binding between the counterparties. The trading analyst on desk will record the trade in the blotter window so that the position can be accounted for before its official confirmation by the exchange. This allows us to maintain an accurate outlook on our risk profile. During this time period we are being credited by the brokerage until this trade has been confirmed by the exchange and the clearing bank. The broker then officially records and posts the trade via the exchange of choice (generally ICE) within 15 minutes of the verbal confirmation and internally logs their brokerage fee to be invoiced to the firm at the end of the month. After ICE has received the trade confirmation they will immediately publish it to the open market. Our internal systems will then pick up the trade with our name on it and match-off the trade which was previously blottered. From there the responsibility of Dare, the brokers and ICE becomes limited and the clearing bank takes over many of the responsibilities associated with the maintenance of the position.
The clearing bank takes a record of the exchange at the point when it is published by ICE on our behalf and handle the mechanics of the processes from there. They are responsible for maintaining the margin for the firm as well as processing the deposits required to maintain futures contracts. I assume they are also in charge of exchanging cash flow between counterparties during swap roll-off.
Any roll-off associated with holding the position is also managed by the clearing bank and the admin procedures of cash exchange mechanics remain opaque from the counterparties perspective as a result. Technically the firm never fully backs away from a position. All swap exchanges are processed by the clearing bank on behalf of the firm despite the fact the firm no longer sees the position on their sheet as it is completely netted out by holding opposite positions.
A Note on 'Liquidity'
An important concept that is often referenced as a major driving force behind the decision-making process in Dare is ‘liquidity’. Liquidity describes the likelihood that a product can be bought or sold for a good price regardless of the true numerical value of that product i.e. “product X has high liquidity” or “selling in a month of high liquidity”. Some examples include:
- The fishmonger is a high liquidity market for fish, the butcher is a low liquidity market for fish. (Market Liquidity)
- Gold and sand both have value but gold has much higher liquidity than sand i.e you’d have a difficult time selling sand at a pawn shop (Product Liquidity)
- Summer has higher liquidity for ice cream than winter (Time Liquidity)
- A merchant provides market liquidity for the product they deal in
- Energy Commodity Trading firms provide liquidity to the oil market
This concept is particularly expressed with regards to time i.e the most liquid point in a calendar. These are:
- December
- Quarter End points
- The front-month (Generally the next calendar month but can be the month after if you are at the end of the current calendar month)
We try to ground all trades around these points of high liquidity in an attempt to minimise our risk, specifically our liquidity risk which will be discussed further in later sections. Fundamentally, if you are in a position of high liquidity you are far more likely to make money on a trade than if you are in a position of low liquidity.
