Negative derivatives pricing

In my “Properties of Stock Options” lecture note, a particularly important theorem relates to the notion that derivatives (options) prices must be non-negative.  Interestingly, back in April 2020, prices for oil futures contracts actually turned negative; see the Wall Street Journal article entitled “U.S. Oil Costs Less Than Zero After a Sharp Monday Selloff” (an ungated PDF version is available at https://bit.ly/oilpriceshock). Quoting from that article, “The unusually large difference in price between oil for delivery in May and later has traders filling up tankers and setting them adrift.” Basically, if you had the means to store oil in the meantime, (e.g., offshore in a very large crude carrier) it made a lot of financial sense to be paid to assume ownership of the (negatively priced) May 2020 contract, and sell a later dated futures contract at which time you could deliver the goods! Apparently, somewhere off the coast of South Africa was an especially popular place to anchor due to its relatively equidistant access to markets in Asia, Europe, and the Americas.

In closing, the following related video from wsj.com is well worth 95 seconds of everyone’s time!

U.S. oil futures plunged below zero for the first time in history, signaling the little storage capacity there is. WSJ’s Spencer Jakab explains how we got here and what to expect next.

One Reply to “Negative derivatives pricing”

  1. I thought this unique event in history was a great connection to what we learned in the readings. While our rules state that these prices should never go negative, the theory does not take into account the market participants who physically can’t take delivery of the asset they are trading. Interesting part is that many people didn’t think this could ever happen. In fact, there were several brokers who weren’t quoting the correct price for WTI that day since their systems never accounted for a negative sign in front of a WTI contract. Only after the fact did many people (including myself) realize this was even a theoretical possibility.

    My boss at the time made a very convincing argument that maybe traders who can’t take physical delivery of a commodity shouldn’t be allowed to trade the futures. This would help to avoid extreme volatility when the economy sees extreme demand shocks. For some context, I remember WTI was moving consistently 1000 – 2000 basis points almost everyday that month. Although he may have just been frustrated because the bets in the energy sector made in the portfolios were tanking.

    Frankly, I do not know enough about it to have my own opinion but I enjoy looking at market anomalies like this since it can show the disconnect between theory and application that exists in today’s markets. After all that’s why working in markets is so much fun. You get to learn something new virtually everyday!

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