In the previous post, we explored the basics of Butterfly Spread and its benefits and downsides.
In this post, let's learn about how the concept of seasonality can be applied in the context of Butterfly Spread via an example using Natural Gas (NG).
Recap: What is a Butterfly Spread?
Essentially, a standard butterfly spread is a simultaneous buying and selling of 2 calendar spread contracts.
For instance, (i) the buying of 1 lot Natural Gas (NG) January/February (F:G) calendar spread, and (ii) the selling of 1 lot NG February/March (G:H) calendar spread makes up for an NG F:G:H butterfly spread.
In other words, a butterfly spread involves a trader being bullish on a calendar spread, while being bearish on another calendar spread at the same time.
To learn more about spread trading, check out my previous articles below:
Seasonality in Butterfly Spread, a Natural Gas example
Instrument: Natural Gas (NG) futures
Period: November - February
Direction: Bearish
Butterfly Spread: Short April/May (J:K), Long May/June contract (K:M) [Or simply put, short NG J:K:M]
Background:
Thanks (or no thanks) to global warming, the US has been experiencing warmer winter months (Dec - Feb) in the past few years. Since natural gas is used for heating during the winter, a warmer winter means lesser demand for natural gas and larger leftover inventory post-winter season.
As a result, this put bearish pressure on natural gas futures prices during spring season contracts like April and May.
First leg: Sell (or Short) NG April/May (J:K) contract
The first leg of our butterfly spread includes the selling of NG April/May (J:K) calendar spread.
Since April and May are spring months, the market may anticipate lesser NG consumption as the spring season develops. As such, there is very little reason to pay for more expensive price premium for NG contract in May compared to April (where there is even less demand for NG as spring develops).
In other words, if all the fundamentals stand true, the spread between NG in April and May tends to narrow with time especially when it comes to the winter season, in line with the bearish expectation of the future.
However...
However, should there be a shift in fundamental factors, such as a colder-than-usual winter which causes NG demand to be high (and hence pressure on inventory), it'll spur bullish sentiment on the future NG prices. As a result, there will be a price premium for NG contracts for further month (in this case, May) relative to nearer month contracts (in this case, April).
Meaning, fundamental shifts such as a freezing winter will cause the spread between NG in April and May to widen instead of becoming narrower with time.
This is where we need to do some form of hedging on further month contracts.
Second leg: Buy (or Long) NG May/June (K:M) contract
The second leg of our butterfly spread includes the buying of NG May/June (K:M) calendar spread.
This move is considered a hedging move to protect traders from a shift in fundamentals such as colder-than-usual winters.
How does this hedging actually work?
Should a fundamental shift happen (such as a colder-than-usual winter that leads to a lack of inventory), the premium for summer months (eg. June) in the futures market where NG is used for cooling purposes will be higher relative to spring months like May, where demand for NG is low.
As such, in scenarios like this, we could anticipate an increase in the price premium of NG June contract relative to NG May contract.
In other words, if the expected fundamentals of a warmer winter and/or low inventory are violated, the spread between NG in May and June tends to widen which will act as a hedge to protect traders from the loss of the selling of NG April/May calendar spread.
Statistics for the past 10 years
Check out what happens when we take a short trade on NG J:K:M butterfly spread on 21/11, exiting on 10/2 for the past 10 years (p.s. 90% win rate):
Year | Entry (21/11) | Exit (10/2) | Gain/Loss ($) |
|---|---|---|---|
2023 | 0.127 | 0.017 | +$1100 |
2022 | 0.088 | 0.018 | +$700 |
2021 | 0.052 | 0.013 | +$390 |
2020 | 0.056 | 0.003 | +$530 |
2019 | 0.177 | 0.022 | +$1550 |
2018 | 0.04 | 0.008 | +$320 |
2017 | 0.023 | -0.007 | +$300 |
2016 | 0.002 | -0.005 | +$70 |
2015 | 0.065 | 0.002 | +$630 |
2014 | 0.01 | 0.037 | -$270 |
2013 | 0.009 | -0.008 | +$170 |
Verdict: Use the concept of Butterfly spread to build edge via seasonality patterns
By understanding the concept of butterfly spread alongside the fundamentals of the instruments that you are trading, it is very possible to form a unique edge, just like how we demonstrated in this post.
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Disclaimers
Any of the information above is produced with my own best effort and research.
This post is produced purely for sharing purposes and should not be taken as a buy/sell recommendation. Past return is not indicative of future performance. Please seek advice from a licensed financial planner before making any financial decisions.
Leverage is a financial tool that comes with its advantages and risks. Please learn and understand both the upsides and downsides of leverage before using it for trading.
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