While most market participants were trying to get in their vacations before the end of the summer, the markets stayed surprisingly busy this past month. CME Group released the latest data for the month of August is out from the CME Group and there are a couple interesting stories that we can see develop in the data. The first is that Feeder Cattle options hit a record Average Daily Volume (ADV) in August and were up 92% on a year-over-year basis. The other is that the 9% rally in December corn in August saw big volume and open interest increases in the calls, helping corn to a solid first place finish with an ADV of over 100,000 for the month. In Figure 1 you can see big year-over-year changes in several products.
Figure 1: Product Volume for August
|Option Product||August ADV||Year/Year % Change|
|Chicago SRW Wheat||21,650||11%|
|Short-Dated New Crop Option||11,297||15%|
|Ag Weekly Option||7,998||33%|
|KC HRW Wheat||2,354||-53%|
|Calendar Spread Option||2,290||85%|
|Class III Milk||1,419||50%|
Source: CME Group
Despite the volume strength on a yearly basis, most contracts saw a decrease in volatility over the course of the month and ended the month with volatility levels near the lows of the year. This doesn't necessarily mean the volume coming through was looking to sell options, as it may suggest that market makers have brought down the implied volatility in line with falls in historical volatility over a relatively quieter period.
Figure 2: CME Group Volatility Index (CVOL) for Ag products
However, while the CVOL levels are near the lows of the last year, we can see in Figure 3 that the average CVOL for the month, at least in corn, soybeans and wheat, was still consistently higher than each of the last four years. Thus, we had higher vols throughout the month but are ending near the lows of the month.
Figure 3: August Average CVOL for Corn, Soybeans, and Wheat
A big story for the month was Feeder Cattle. With severe drought impacting grazing land and feed costs, there have been record numbers of cattle moved off grass. The uncertainty caused by these drought conditions have led traders to seek the insurance in the options market, leading to an almost doubling of activity on a year-over-year basis. Though seasonally, futures prices tend to top and then move sideways to lower from the U.S. Labor Day holiday into year end. The average over the last 20 years shows a moderately positive month in September but then negative months on average in the last quarter.
Figure 4: Seasonality for Feeder Cattle
Will we buck the trend this year given this exogenous shock from the weather? It is plausible as the industry quickly moves through the supply. We are seeing the demand for call skew steepen, put skew flatten, and the risk reversal move to flat. There appears to be more demand for insurance in upside call options, than in the downside put options despite the negative seasonality.
Figure 5: 25 delta QuikSkew
Looking at the October Feeder Cattle contract, we may see why traders are thinking this seasonal trend may not hold this year. Over the month, the price came down and tested the top of the Ichimoku Cloud, which means the level where volume had accumulated over previous months, suggesting there is demand in the 180 region. We can see in the middle panel that the Moving Average Convergence Divergence (MACD) is crossing and heading higher, another possible bullish signal.
Figure 6: Daily Ichimoku cloud chart
It may be surprising then to see that October implied volatility is below that of the rest of the curve (outside of the soon-expiring September contract). This may suggest that there is an opportunity presenting itself in the October contract on the long side of volatility.
Figure 7: Term structure of implied volatility for Feeder Cattle
This opportunity may look even more compelling when we see that the historical volatility is also above the implied volatility meaning that options are carrying well for traders who are long. If one can cover their daily time decay, or theta, while waiting for the directional move, it gives a trader more time to be patient.
Figure 8: Implied versus Historical volatility for Feeder Cattle
Feeder Cattle straddle example
Pulling this information together, there may be an opportunity to be long straddles on October Feeder Cattle. This point is the low point on the term structure. Right now, options are carrying well, too. I like being long because I can delta-hedge and make money near term. The futures appear to be setting up for a move higher and options traders are anticipating this. However, we also know there is negative seasonality over the fourth quarter. A trader who gets long the straddle can re-hedge the position and cover time decay while waiting for a move to develop. Once the trend asserts itself, perhaps higher as the charts suggest, or lower, which may catch more people off guard. The trader may then let the deltas run and not re-hedge, allowing the position to gain in value. As established, the breakevens of the straddle are approximately 178 and 192 versus the 185 futures price. However, any money made in the near-term hedging deltas will reduce the breakeven levels of the straddle. The trader also benefits if volume flows continue to be strong and implied volatility moves higher. This type of trade does require a great deal of attention as the trader must be watching for opportunities to hedge and watching for news that the trend move is confirmed.
Figure 9: Expected return and Greeks for the Feeder Cattle straddle
Corn short call spread, long put strategy
Not unrelated to the Feeder Cattle price is the price of corn. One of the things driving up the price of cattle is the feed cost, or the cost of corn. December corn rallied close to 9% in August as market participants ramped up open interest in the December $7 call as the 25-delta risk reversal decreased from 4.66 to 1.62.
Figure 10: Corn volume and open interest
However, a look at the charts suggests this price may be running into resistance at this $7 level. The Ichimoku Cloud resistance is at this level, the MACD is rolling over and looks set to head lower, and the RSI also looks to be pulling back.
Figure 11: Daily Ichimoku Cloud for Generic front month corn
With the demand having been focused on the upside, and a trend trying to begin anew after a market that was flushed out in July, a rally that stalls here have the potential to lead to frustration among traders who are not too far removed from a very difficult Q3 in terms of price action. As we have highlighted before, the seasonality for corn in the last four months of the year tends to be quite positive. This may be another motivating factor for traders to be seeking the upside.
Figure 12: Corn futures seasonality
Corn skew has flattened out over the course of the month of August. The risk reversal was last this flat in the early part of the summer when we were at much higher prices.
Figure 13: One month 25 delta risk reversal price for corn
This has been matched with a flattening of the cost of the 25-delta put relative to the ATM for corn as well. Both point to downside put options being at a relatively low price versus the other options around it.
Figure 14: Corn put skew
Traders may not want to be short upside options given the positive seasonality. Since there has been demand for the $7 strike, we anticipate and can see that there is a bid in implied volatility at this strike. We can fade that by selling the 700 calls to buy 600 puts. To cap our losses, in case we are wrong and positive seasonality occurs, we can buy the 750 calls to stop ourselves out. This package is roughly zero cost. It has unlimited potential gains on a move lower, but risks are capped at 50 cents. We can use the Matrix function in QuikStrike to see how the PnL of the trade develops at different levels of spot and implied volatility. It is a bearish idea, and we can see that in the chart below. However, even if implied volatility moves lower with futures, the position still profits. On the move lower in July, we saw both implied volatility and skew moving higher which would potentially benefit this idea even more. We are selling the calls on a 28.3 volatility and buying the puts on a 27.5 volatility, so we benefit from the skew having moved in favor of the calls.
Figure 15: Matrix of PnL for a short call spread, long put corn trade
While there is risk on a move higher on this trade, we should remember that we are somewhat protected if we also bought the Feeder Cattle straddle, as prices there would be affected. We are also long those options on a 12.4 implied volatility while short these $7 calls on a 28.3 implied volatility.
Figure 16: Short call spread, long put corn strategy
I am not suggesting that a trader should or would look at this as a spread idea. However, as we have seen across all assets this year, when we see macro events and exogenous shocks, there are correlated risks in one’s portfolio they should be aware of. In this case, a trader who does both ideas would potentially benefit from these correlated risks, or at least have protection from gains in the long straddle position to cover some of the capped risks in the corn position.
To read additional option reports from Rich Excell, visit cmegroup.com/excellwithoptions
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