Use Cases for Short-Dated vs. Deferred-Month Grain Options

Volatility during the spring planting season is nothing new as the weekly chart of corn below shows.  Prior to the advent of the CME’s short-dated options on new crop corn, the most viable options one had at their disposal to hedge or speculate with at this time of year were the December options that expired the end of the third week of November.  With short-dated options, the same hedge and spec strategies on the December contract can be structured for more immediate performance because of their higher gamma (rate-of-change of delta) and lower time premium.  And while such nearby short-dated options incur higher theta (time decay) risk, their gamma and lower time premium benefits can outweigh their theta risk when a strategy is structured properly.

As an example, in the weekly corn chart above we acknowledge the resistance from the $4.40-to-$4.60-range that has capped this market for the past four years.  A producer can structure an effective hedge strategy by selling the $4.50 - $4.70 call spread and using the proceeds to purchase an out-of-the-money put to hedge his exposure to lower prices at a low initial cost with fixed limited risk should the market continue to rally.   The cost/benefit merits of this “combo” strategy vary however depending on whether the producer uses the Dec options or the August short-dated options.

Using the December options and as of this writing (6/5/19), the Dec 4.50 – 4.70 call spread trades at approximately 6-cents.  To purchase an out-of-the-money put needed for downside hedge protection while also trying to keep the cost of this hedge close to “even”, the producer could purchase the Dec 3.80 put for approximately 8-cents for a net cost of the hedge of about 2-cents.  The P&L graph of this Dec “combo” is shown below with a downside breakeven point at expiration of 3.78.  There are 170 days to expiration on 11/22/2019.

The table below shows a net delta on this Dec19 example of -26% along with the remaining gamma, vega and theta metrics.

Structuring this same strategy using the August short-dated options produces a similar but more acute P&L performance.  The Aug short-dated 4.50 – 4.70 call spread sells for a little over 5-1/2-cents.  This would allow for the purchase of the Aug short-dated 4.00 put around 7-cents for a net cost of the strategy of about a 1-1/2-cents, or about the same cost as that for the December combo.

As usual between nearby options versus deferred-month options, theta risk of the nearby comes in exchange for higher gamma and lower time premiums that, in this example, produces a downside breakeven point at expiration of 3.98, 20-cents higher than that of the Dec strategy.  At a time of year when volatility is typically high, such a tighter breakeven point where hedge protection will kick in sooner may be considered preferable by producers.  Both strategies have fixed/limited risk of approximately 22-cents on any rally above 4.70.

It is acknowledged that this Aug short-dated hedge strategy is only effective for 52 days to expiration (DTE), considerably shorter than the 171 DTE in the Dec strategy.  This difference requires more acute management of the strategy that may need to be repeated after the Aug short-dated options expire.  The Aug short-dated combo comes with a higher net delta of -32% and theta risk roughly 2.5-times that of the Dec strategy.  But again, the benefit of a downside breakeven point 20-cents higher than the same strategy using Dec options is considerable.

An example of a similar but inverted “combo” strategy shows similar gamma and time premium advantages that would apply to end-users looking to hedge their exposure to higher corn prices.  Referring to the weekly corn chart once again below, the market’s breakout above the past couple years’ resistance from the $4.10-to-$4.20-area leaves that now-former resistance in its wake as a new support candidate from which bullish hedge and spec option strategies can be structured and managed.

An example of a strategy with fixed and limited downside risk and unlimited upside potential would be a “combo” that involves selling the Dec 4.20 – 4.00 put spread and then looking for an out-of-the-money call for roughly that same price that would present a low-cost and provide upside potential.  Basis the December options, the 4.20 – 4.00 put spread trades around 9-1/2-cents.  Buying the Dec 5.40 call that currently trades around 10-cents would create an overall strategy that costs about a ½-cent.

The P&L graph above shows an upside breakeven point and performance at 5.40-1/2 at expiration 170 days from now on 11/22/2019.  The table below shows a current net delta of +30% along with the other Greek metrics.

Applying this same strategy to the August short-dated options, the end-user would be able to sell the 4.20 – 4.00 put spread for around 7-1/4-cents.  But because of the lower time premium in options that expire in 51 days rather than 170 days, traders only have to go out to the Aug short-dated 5.00 calls to find a similarly priced option to the put spread.  At a price of only around 8-1/2-cents for the Aug short-dated 5.00 calls, this entire strategy could be bought for a net cost of about a penny.

While the table below shows the theta risk of this Aug short-dated strategy to be 2.5-times that of the same bull combo strategy using the Dec options, the Aug short-dated options enjoy a higher initial net delta of +37% (vs +30% in the Dec combo) and a much closer upside breakeven level at expiration of 5.01, 40-cents closer than the 5.40-1/2 breakeven in the Dec strategy.  Here again, at a time of year when volatility and risk premium is typically higher due to planting risks, end-users and speculators may consider a much closer breakeven point preferable in a strategy that has a 51-day life span to one that spans an additional four months and a breakeven point 40-cents farther away.

While more acute management and slightly higher theta risk are acknowledged in a corn strategy utilizing CME’s August short-dated options versus an identical strategy using December options, the gamma and lower time premium advantages the nearby Aug short-dated options enjoy over the deferred-month Dec options produces much closer breakeven levels at expiration for basically the same cost/risk that can prove beneficial during the typically more volatile planting season.  These advantages come in exchange for more acute management of the short-dated strategies since they expire in 51 days, four months sooner than the Dec strategies, and may have to be repeated after they expire if the hedge or spec conditions still warrant such strategies.

In the above examples we used a “combo” strategy to compare an August short-dated strategy to the same strategy using the December options.  The benefits derived from the short-dated strategy should apply to any comparable strategies between the two months (i.e. back spreads, ratio spreads, butterflies, etc.).