The second quarter of 2022 was not very kind to investors in any asset class or in any geography. As the bear market in equities and bonds continued to deepen, even the diversifying returns in the commodity asset class began to suffer. This was no different in grains or livestock. While prices for both held up well in April, the livestock prices already began to suffer going into May. Grains followed suit for a weak May and even weaker June. Even the acreage reports at the end of June could not put a bid into the markets as we ended a tough quarter.
That doesn’t mean the options market was not busy. In fact, people often turn to the options market when there is uncertainty. Options typically serve two purposes in investment portfolios. They can be used for income generation – typically upside call selling against a long position – which has been quite popular in a world that has been, until lately, starved for yield. However, the more common use for options is as insurance. In fact, many of the terms we use in the options market come from the world of insurance – contract, premium, expiration, etc.
When investors become less certain about the future direction of an underlying, or the future profitability of their portfolio, they tend to turn to the options market to find better ways to express their views. Options can provide this embedded insurance, as well as leverage, that can help portfolios generate better returns than may be otherwise possible. The drag from only spending premium is something the more sophisticated options users concern themselves with but can create a dynamic market that opens a world of possibilities.
It is this type of market that we saw in the agriculture world in June. Given the material strength in commodity prices of all types this year, given all the events unfolding throughout the world the past year, the agriculture market may have many participants that go beyond the standard producer, end-user, and speculator. In the first quarter, commodities were the only asset class with positive returns, so it isn’t a stretch to think there may have been more money allocated in that direction. Given the struggles in the second quarter, these positions may have been part of the demand we saw for all options products.
From CME Group data, here are a few of the highlights from the Agricultural options market in June:
June 2022 highlights
- Short-Dated New Crop options reached 330K contracts in open interest, the highest level since 2015, and 79,789 contracts traded June 23, the largest trading day since 2016.
- Live Cattle futures have increased in price over the last two years as volatility has decreased and call skew has increased. Spread trading has been the majority of option volume for the last three months, with verticals and three-ways being the most popular strategies.
- Wheat CVOL (WVL) volatility and call skew have not subsided to levels pre-Ukrainian invasion.
- The Corn option complex (SDNC/CSO/weekly/standard) reached the third highest level of open interest in 37 years on June 22, with 2,406,655 contracts outstanding.
As you can see, volume numbers set records in June, particularly in Corn options. With this much activity, one might think there is opportunity. This does not suggest that the crowd is always wrong. In fact, as James Surowiecki wrote in The Wisdom of Crowds: “Homogeneous groups are great at doing what they do well, but they become progressively less able to investigate alternatives.” Groups of investors, focused on inflation as the most important issue, are great at identifying those assets that will help their portfolio. As we have seen over the last decade, grains and livestock are positively related to CPI data. GDP data, on the other hand, appears to lag them both.
Figure 1: Ag futures compared to CPI and GDP
Surowiecki is not the only author to have written about crowds. Charles Mackay wrote his book called Extraordinary Delusions and the Madness of Crowds in 1841, over 150 years before Surowiecki. He would counter the claim on crowds above with: "Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, one by one." While many moved into the world of commodities to protect themselves, perhaps with the benefit of hindsight, we might think that it was this same herd behavior that led to the second quarter price action. After all, who would be left to buy and take prices higher? If we consider the price action of Agricultural futures, the CRB Index or the Bloomberg Commodity index, regardless of the product, it had the same price action over the second quarter. In fact, the price action for the last year has shown that it is tracking the market expectations for central bank rate hikes over the next year. At this point, those expectations are coming lower, perhaps because it is now growth concerns and not inflation concerns that are bubbling to the surface.
Figure 2: Commodity futures and Fed rate hikes
If we look across the various CME Group futures products, we see a higher cross correlation between products in the last nine months than in the five years before that.
Figure 3 & 4: Cross correlation of future products the last nine months
Typically, when correlations are moving higher, it is a time of risk reduction. Asset allocation frameworks from Markowitz to Black-Litterman suggest this. Investors are in search of uncorrelated (or ideally negative) streams of alpha. When those return streams become more highly correlated (and negative), it becomes a time to reduce risk. This is also a time when investors seek the insurance of the options market. We should expect to see the overall cost of insurance rising. For most of the Ag products, it is above the midpoint of the last six months and recently trending higher.
Figure 5: CVOL for Ag products
Trying to put this together, we are seeing highly correlated moves in all futures products. This may well be a function of risk reduction and position liquidation that is the result of central bank rate hike expectations. These expectations have come lower as growth is falling and expected to bring inflation lower with it. The position liquidation is driving an increase in implied volatility, and in some cases an increase in skew, as investors seek the insurance of the options market. How does one try to find opportunity?
Going back to the beginning of the note, we have seen Live Cattle futures increasing for the last two years, driving a decrease in implied volatility and an increase in call skew. We might now be seeing the opposite occurring.
Figure 6: Live Cattle implied volatility and call skew
Managed futures accounts are reducing longs and increasing shorts, which is adding to pressure on the futures price.
Figure 7: Live Cattle Commitment of Traders report
The generic front month futures price is moving below the Ichimoku cloud, or the prices where most of the volume both long and short has occurred. This also has led to the MACD rolling over. A weak technical set-up combined with systematic traders reducing longs and adding to shorts. It may not be surprising to see implied volatility beginning to react.
Figure 8: Generic front month Live Cattle futures Ichimoku cloud chart
However, as we look to the end of the calendar year, we see that it seasonally tends to be a stronger period for Live Cattle futures. Perhaps the global risk reduction is creating an opportunity?
Figure 9: Live Cattle futures seasonal performance
The highlights for June showed a preference for vertical and three-way spreads among the investor base.
Figure 10: Live Cattle option investor preferences
We also see that the risk reversal price out to December is now showing an investor demand for 25 delta puts vs. 25 delta calls.
Figure 11: Live Cattle risk reversal prices
Live Cattle options trade
Traders who are either looking to find an entry level on the long side in the face of the risk reduction, or who are looking to convert a long futures position into an option strategy to reduce their risk, can perhaps find this opportunity using one of the popular three-way trades from other parts of the ag market. This would lean on the idea that Live Cattle has positive seasonality into the end of the year, as well as the notion that call skew, which had been increasing the last two years, has moved back toward the puts recently.
A trader looking to get long via the options market may sell puts that have a relatively elevated volatility and use the proceeds to buy calls. Since there may be concern of price gaps given risk reduction, however, a trader could look to sell a put spread and use these proceeds to buy a call that is struck a bit further out of the money. In this example, I have sold the 140-135 put spread for December expiration and used the proceeds to buy a 154 call. The trade is roughly premium neutral but has a long delta, gamma, and vega profile. With the futures price at 144, the breakeven is 154, so it is set up to be a bullish idea. Again, this is for the trader already looking for ways to get long or to replace their long futures with a potentially more profitable options position.
Figure 12: Live Cattle bullish options trade
Another highlight from the month of June was the interest in Short-Dated New Crop options. We can see from the chart below that this category ranked third in average daily volume over the course of the month.
Figure 13: June average daily volume of option products
|Option Product||June ADV||Year/Year % Change|
|Short-Dated New Crop Option||28,891||-3%|
|Chicago SRW Wheat||26,154||47%|
|Ag Weekly Option||6,949||-22%|
|KC HRW Wheat||3,255||40%|
|Claendar Spread Option||2,936||62%|
|Class III Milk||739||-41%|
Source: CME Group
Figure 14: Non-standard corn market share
Going back to the trusted seasonality chart, we can see that generic front-month Corn futures have tended to struggle through the summer months, but as we get to the new crop, prices in December and into the new year have recovered.
Figure 15: Corn generic front-month futures seasonality chart
We can see the Short-Dated New Crop interest in the August options that settle into the December futures. The open interest in this contract is particularly pronounced on the call side, which may be a function of where prices have come from but could also be indicative of an interest to position ahead of positive seasonality.
Figure 16: Short-Dated Corn open interest
Understanding there is a clustering of open interest to the upside of this contract, a trader may feel that even if there is a rally, there will be some friction to prices moving higher as we move back into an area where there is long gamma among traders. Thus, a trader who is long and looking to gain leverage on an upside move, or a trader willing to bear more risk and wanting for an inexpensive way to get long Corn, with limited risk on a move lower in futures, but more substantial risk if the price moves above their target, could consider a 1 by 2 call spread. I personally prefer 1 by 2 ratio call spreads to get more leverage on my existing long ideas. These are ideas I am already comfortable with from a directional standpoint, but where I want to gain more leverage on the move. The low premium 1 by 2 call spread allows this trader to gain leverage on an upside move. The aggregate position (if done vs. a long underlying position) acts like a long call spread AND a long buy-write. In this case, for little premium, the trader can profit from 611 up to 688 in the futures, being taken out of the position on a move above that.
One may consider using this as a directional idea on its own if they understand the risks. For one, while this low premium call 1 by 2 will not cost a trader if the futures contract moves lower, as would be the case if the trader bought futures instead, it would cost the trader if futures moved too much in the direction they are expecting. As I mentioned, the breakevens are 611 and 688 versus the current futures of 575. This means if one wants to use this as a long position, and the futures move too far to the upside, the trader could lose money. For those who feel it is difficult enough to get the direction correct, this might not be appealing.
The other thing to understand is that this call 1 by 2 will not carry well initially. On the initial moves higher, the mark-to-market could be negative as the further out-of-the-money option may gain value more quickly. However, if a trader understands these risks, understands that there may be friction to a move too far to the upside, and that the position can give leveraged gains for a move higher, within a range, the 1 by 2 call spread may be the trade for them.
Figure 17: 1 by 2 call spread
The Agricultural options market had a very healthy volume month in June. Often a trader can look to where the volume is trading, trying to decipher why that is the case, and find opportunities. If the trader combines that options knowledge with other sources of views, potentially interesting tactical options positions may result.
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