Executive summary



Ag markets are heating up - macro drivers and option strategies


As we discussed last month, the agriculture complex had a difficult second quarter. There were probably many that were hoping for a bit of a reprieve in the month of July. However, that was not in the cards with an index of the combined performance down another double digits at the lows last month before recovering about half of the performance late in the month. There still appears to be a major ‘macro’ influence to this group as it has tracked (and been led by) investors inflation expectations as backed out of the TIPs and Treasury market.

Figure 1: Ag futures vs. Inflation Expectations (10 year Treasury less TIPs yield)

In markets like we are seeing, investors prefer the insurance of the options market. The options market is a place where we can all buy and sell insurance, unlike any other insurance market. The positive convexity and unlimited potential gains of the portfolio hedge part of the options market can be quite appealing when one’s directional calls are not working according to plan. It is no surprise the options market has increasing levels of interest with the recent batch of earnings, economic data, and updates from the Federal Reserve.

Based on CME Group Ag Options Update, here are a few of the highlights from the agriculture options market in July:

Ag Option Product Suite July 2022 Highlights

  • The Short Dated New Crop (SDNC) option complex had an a ADV of37K contracts trade in July, an all-time monthly record. SDNC Soybeans traded over 13K ADV as November volatility averaged 27%, a level not seen since 2012
  • Class III Milk options along with the entire Dairy complex are sitting at record open interest.  A testament to how participants are utilizing Dairy Revenue Protection (DRP) contracts alongside exchange traded products.
  • The QuikStrike Vol2Vol tool, shows a 32% chance November Soybeans could settle below $12.70 or above $16.70 and December Corn settling below $5.00 or above $7.40 as we head into the North American harvest season.

Figure 2

You can see across the spectrum, the year/year changes in the average daily volume are up rather meaningfully. Corn is the leader and almost always the big dog, however, there are a couple other places I want to draw your eye. The soybean complex had a strong month of July culminating with some big moves in the last week. As we are in the heat of the summer, perhaps this is not surprising. What may be surprising, though, is the growing interest in the Class III Milk options market. Let’s look at option strategies in both the Soybean and Class III Milk markets.

It’s not just the weather that is hot

In fact, because of the hot weather, we are seeing the soybean complex as the biggest mover in the last week, and one of the most active in the month of July. I don’t know about you, but I am always drawn to where the action is busiest. I recall from my early days on the floor of the CME, when we would hear a loud yell on one part of the floor the local traders with the gold badges that allowed them to trade in any pit would always run to the noise. I was somewhat envious of the flexibility these traders had to go to where the action is hot. However, going to those places, it is sometimes difficult to know if you are a moth drawn to a flame or if you are more “Marines mov(ing) toward the sounds of tyranny, injustice and despair—with the courage and resolve to silence them.” (Marine commercial)

For me, the way to distinguish between the two is to do your homework and have a disciplined process. This will give you the knowledge to know what you know and, importantly, know what you don’t know. As I told my son when he was a teenager, if you don’t know who the sucker at the card table is, it’s you.

The process for me begins with assessing the levels of volatility in the market, where a product’s volatility is in relation to its own history and relative to other products. This can help me begin to understand if the price of an option is worthy of considering buying or if some of the worst news may be closer to being priced in. When we look at the CME CVOL tool for the Agriculture complex, we can hone in on soybeans and see that the current level of volatility is at the 1 year high and has been trending higher for weeks. In fact, at 36, the current CVOL is not too distant from the all-time high of 43. Suffice to say, with the volatile price action in beans, the demand for insurance protection is high.

Figure 3: CME Group Volatility Index for Agriculture

I then want to know what the longer-term patterns are in the underlying price. We know there are some macro drivers influencing price trends. We can see that the recent hotter than expected weather has given rise to a move higher in futures. However, it is summer, so isn’t it always hot? What we see over the last 15 years is that the summer months have tended to be a struggle for soybeans, while the 4th quarter and the new crop are a time of recovery in prices. We can see this in the summary data from CME as well where Short Dated New Crop (SDNC) Soybeans traded over 13K ADV. We can also see that 2022, as uncommon as it may feel given much of the news this year, is following along the pattern of the last 15 years, with a strong Q1, a strong Q2 (though front-loaded), and a weak Q3 (so far at least). Will this Q4 pattern hold?

Figure 4: Generic Soybeans futures seasonality

There is another tool that is quite useful and which you should be aware of, the CME Vol2Vol tool. This tool uses options market data to indicate the expected range the market forecasts the underlying to stay within. This range is indicated by the shading on the graph, with the darkest shade the 1st standard deviation (s.d.) from current, the medium shade the 2nd s.d. move, and the lightest shade the 3rd s.d. We know from options pricing that this means the market expects the underlying price to stay within 1 s.d. about 68% of the time. The ranges in dollar terms make it easy to identify the range. In this case, it says for the November expiration, with futures currently about 1400, the options market expects the underlying to stay in the 1200-1600 range about 68% of the time.

Figure 5: Vol2Vol for November Soybeans

If I plot the 1200 and 1600 levels on a chart of the November soybean price, we can see that this range encompasses the entire trading range for the last year. Recall, we said when we looked at the CVOL tool, that implied volatility was elevated in the soybeans. Perhaps this is too elevated?

Figure 6: Soybean futures price with Vol2Vol range overlaid

Looking at a history of the soybeans CVOL index, the skew, and the underlying, we can see that volatility and skew both rise and fall with the underlying price, but lately have both risen much more than the underlying price.

Figure 7: Soybeans CVOL history

If I put this together, I see several signs that the demand for insurance in the soybean market is elevated. I look at the expected range until November and it is wider than what we have seen this year and that is just the 1st standard deviation expectation. I know that Q4 seasonals are directionally strong, but if the pattern holds, we could still see weaker prices in Q3 ahead of that. Importantly, this is being anticipated so it should not surprise many. Implied volatility and skew have risen in anticipation of a rally in the underlying but could those traders be disappointed? My instinct is to sell this implied volatility level. However, I recognize not everyone wants to, or even can, sell a straddle and re-hedge the deltas each day. Sometimes one’s risk management guidelines do not allow for this open-ended risk.

One variation of selling a straddle and re-hedging deltas as a way to express a short volatility view, is to use an iron butterfly. In this strategy, the trader sells the at-the-money straddle, and then buys an equidistant strangle to cover the tails in either direction. The premium spent on the strangle does eat into potential gains, but it also quantifies the tail risk of the strategy. A defined risk and reward can be established.

In this example, I look at the November options and sell a 1400 atm straddle. I then cover the tails buying a 1270-1530 strangle. My breakevens on this strategy are 1305 and 1495. At expiration, my max return is 94.50 and max loss 35.40 for about a 2.7 to 1 reward to risk, which is attractive. You can see from the expected return chart below, the payout is much flatter and smoother in the early days of the trade. It isn’t until we get much closer to expiration that the structure decays (collects theta) and the profits potentially grow. One can either accept the reward to risk and look at it as a “set-it-and-forget-it” idea or more actively manage the strikes as the underlying moves. I have drawn the 1300 and 1500 breakevens on the graph of the underlying above. The iron butterfly (or its cousin, the iron condor which just substitutes the atm straddle with a tight strangle) is a way for a trader to express a short volatility view while defining the risk of the idea.

Figure 8: Expected return of a November soybean iron butterfly

Got Milk (options)?

Why yes, yes we do!

Noted above: “Class III Milk options along with the entire Dairy complex are sitting at record open interest.  A testament to how participants are utilizing Dairy Revenue Protection (DRP) contracts alongside exchange traded products.” Digging into this further, we can see from the USDA website:

“Dairy Revenue Protection (Dairy-RP) is designed to insure against unexpected declines in the quarterly revenue from milk sales relative to a guaranteed coverage level. The expected revenue is based on futures prices for milk and dairy commodities, and the amount of covered milk production elected by the dairy producer. The covered milk production is indexed to the state or region where the dairy producer is located… The Class Pricing Option uses a combination of Class III and Class IV milk prices as a basis for determining coverage and indemnities.”

Dairy Revenue Protection is a program that started in October of 2018. It has seemingly taken a little time for market participants to get used to this program, and how to use it in conjunction with exchange-traded products,, but the comfort level seems to have grown. Since the summer of 2020, open interest in the Class 111 Milk options has been steadily growing. Recently, Class III Milk options traded close to 2k ADV in July helping to push open interest to the second highest level ever at the end of the month.  The entire Dairy complex is showing strong open interest closing out July at close to 300K outstanding, highest level ever.

Figure 9: Class II Milk open interest

Referring to the CVOL chart at the top of the page, we can see that despite this open interest growth, Class III Milk options volatility at 20 is relatively expensive versus its own history and across the rest of the agriculture product. Is there an opportunity for the trader that may not have exposure to the DRP but wants to express a view on growing interest where there might be inexpensive insurance?

We should also look at the history of CVOL relative to the futures to see how market players react to bigger moves. The history for Class III Milk (DCVL) helps illustrate how implied volatility spiked as futures started to decline at the end of June and into July. It has come lower as futures stabilized but we can see it is still below where it was at the start of the year when futures were higher.

Figure 10: Class III Milk CVOL history

If I look at this level of implied vs. the actual or realized volatility a trader would see that the level of volatility (here at 21.8) is lower than how the future has actually moved over the last 1 and 3 months.

Figure 11: Milk implied vs. realized volatility

Comparing the difference of implied and realized volatility, we can see that the level of implied volatility a trader must pay is 3 standard deviations cheaper relative to realized volatility. This is a discount of implied volatility rarely seen across many assets.

Figure 12: Spread between implied and realized volatility

We can also see the futures open interest has been growing throughout the year in addition to the options open interest. The price has come lower and sits below its moving averages. Has the trend changed? Is this a directional opportunity? If we are buyers of volatility, does it matter?

What might be clear is if the trend resumes, a move above the moving average resistance in the 22-55-22.85 level could lead to a quick move back toward the highs of 25. Conversely, we might continue to drift lower though the market has already given back $5 of the $8 rally over the past year.

Figure 13: Milk futures price

Overall, I see a preference for wanting to be long options in milk. We see growing interest in the futures and options market, perhaps because of the DRP, or perhaps for other reasons. The price pattern has followed what we have seen in all other Ag futures, which could suggest a rally is in order as the others have rallied. The moving average at 22.75 could be resistance, but above there, one might suggest open-ended profits could be had. Of course, we should always be cognizant of a drift lower that cancels this. Finally, looking at the CVOL for Milk, as well as comparing the implied to realized volatility, we can see Milk options look relatively inexpensive vs. actual movement, based on its own history and the rest of agricultural options.

How might one take advantage? One option would be selling 1 atm (20.50 strike) September Milk call and using the proceeds to buy 3 otm (22.50 strike) Milk calls. I am net taking in a small amount of premium so if the futures stay here or move lower, I will make a small amount of premium on the idea. If futures move higher, especially in the near term, I have a leveraged position to the upside, with a breakeven at expiration of 23.40, but profitability accruing earlier the sooner the move happens as you can see from the steeper shape of the curves at current time and T+16 days. The biggest risk, which would be a loss of money, is going to the long strike, right at the moving averages, and being there at expiration. So the idea is not without risk. However, the trade can make money by taking advantage of relatively lower implied volatility whether futures move lower or back to the highs of the year. A drift higher is the enemy of this idea.

Image 14: Breakeven of ratio call spread in Milk

The agriculture options complex is continuously growing. New records have been set the last two months. However, if one does their homework, they can still find interesting ideas that can fit their underlying views. There is often some hesitancy into moving into new options markets. If you trade the underlying, you have more of a view on implied volatility than you think. You may have an idea of where futures can go directionally and where the risk is on the idea. This is the beginning of an implied volatility distribution. With the help of the Vol2Vol tool at CME Group, you can see where the market is pricing the distribution of outcomes for each market and see if you agree or disagree. With CVOL and other tools, you can also get a good idea of what is priced into the current options market, helping you make more disciplined and informed decisions. Remember, it is always interesting to go where the action is hottest, but you also want to make sure you are prepared.

Good luck trading.

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