Executive summary

How is Ag volatility reacting to extreme geopolitical risk? In this month’s edition, Rich Excel examines Chicago Wheat volatility and the growing trend of using weekly options to manage uncertain times. Rich also revisits two options strategies from past issues:

This calendar year has clearly been a year fraught with many risks for investors to sort through for their portfolios and trading. As we can see from the Geopolitical Risk Index put out by Matteo Iacoviello, formerly of the Federal Reserve, 2022 has seen not only a spike in risk but a higher consistent level of risk than any year since 2001-2002. 

Figure 1: Geopolitical risk index

In times of uncertainty and volatility, traders and investors will often look to the options market to find more optimal ways to implement ideas or express views. CME Group has seen consistent growth in ADV and OI across most of the Ag products throughout the year, and September was no different. Most products continued to see large year-over-year changes, but a few stood out:  Feeder Cattle with 73% YOY change, Wheat with 61% YOY change, and Ag Weekly options with a 40% YOY change. 

Figure 2: Average daily volume and year-over-year change by product

It is very interesting to see the Ag option complex following the pattern of all other option markets, where weekly options are becoming more and more popular among traders. Whether it is a more convex replacement for delta in some accounts, or more instant gratification than longer-dated options in others, it is a trend we have seen across all markets for many years now. This may be indicative of more financial buyers or traders involved relative to end-user demand. These types of changes in flows can present opportunities to traders who are diligent in how they sort through the data.

Figure 3: Weekly options average daily volume and open interest

It is also a trend that traders can focus on when there is news in the market that impacts a portfolio. Portfolio managers look to the insurance value of options when uncertainty hits. For example, on September 20, SRW Wheat CVOL (WVL) shot up over nine vol handles in one day with continued geopolitical news coming out of the Black Sea. This is the fifth biggest one-day change for the Index, the other top four occurring during late February and early March. Given the geopolitical news on September 20 price, volatility and skew had a significant reaction. Below is a chart showing the one-day change of WVL, measuring volatility for wheat.

Figure 4: Wheat CVOL changes

We can see where the nervous side of the market was as well. Not only was there an outsized move in all implied volatility, but this reaction was most pronounced in upside options. This can be seen in the CVOL Skew Index. This Index for SRW Wheat shows the outside reaction to the upside that occurred on September 20.

Figure 5: Wheat CVOL Skew history

It was also apparent but not as pronounced when we look at the 25 delta risk reversal prices. While a relative preference for upside options had occurred since the beginning of August, the 10-volatility point difference between puts and calls was the highest in six months and more than double what it had been even a few weeks prior. 

Figure 6: Wheat 25 delta risk reversal price history

We also see this in the call skew of the market. Upside calls are favored relative to ATM, relative to downside puts, and even relative to calls that are not quite as far out of the money. The demand for this insurance presumably on the back of geopolitical events is quite apparent.

Figure 7: Wheat Call skew price history

This demand was even enough to get the 30-day implied volatility to move above [KK1] the 20-day historical volatility, something that had not happened since the start of the year.

Figure 8: Wheat implied vs. historical volatility

Traders may not see this as anything more than a temporary move, however. Judging by the term structure of implied volatility, the steep downward slope suggests traders feel this is mostly a short-term risk in the market as the implied volatilities above 50 are gone by the end of the year and continue to slope downward throughout next year.

Figure 9: Wheat implied volatility term structure

It may not be surprising that the expectation is for a fall in implied volatility since SRW Wheat CVOL is at the highs of the last six months. The only other Ag product that is also at its six-month high in CVOL is Class III Milk. Even with all the uncertainty in the market right now, it appears that a good amount of anxiety is being priced into the options market.

Figure 10: Ag product CVOL

This nervousness has been most pronounced on the upside of the market as I mentioned before. In some ways this is surprising, since the normal seasonality of the Wheat market over the last 15 years is for strength in prices the entire September-December period. However, one thing that does stand out, is the strength we have already seen in September is far more than what might be considered normal. September saw prices up almost 14%, which is the second biggest up move for a September in the last 15 years, and certainly in the top 10 of all monthly up moves.

Figure 11: Generic first Wheat futures price seasonality

This is happening at a time when the other potential drivers of Wheat prices – for example, energy (diesel fuel) costs or fertilizer (urea) costs – might be suggesting the price of Wheat should be falling. That said, Wheat had fallen much more than energy costs over the course of the summer, so there may be some catch-up to do for farmers. 

Figure 12: Wheat futures vs. Diesel prices vs. Urea prices

Technically, the generic first Wheat futures also may be poised for a breakout move right now. We can see on the below chart that the price has broken through the Ichimoku cloud, the lagging span is also moving higher into the cloud, and we are not overbought on RSI or stretched on the MACD. The technical picture most likely looks optimistic for many traders.

Figure 13: Ichimoku daily price chart for generic first Wheat future

How can one make trading decisions in a market that has high implied volatility, high upside implied volatility, but where the direction of price both seasonally and technically also appears positive? One might suggest that the options are pricing in this up-move. One might also suggest that the falling prices of energy and fertilizer could put a lid on how high the futures price may go, particularly considering the large move that the price already had in the last month.

Taking this into account, I have looked to take advantage of high implied volatility to be a net seller of options. I particularly wanted to focus on selling upside options as the CVOL Skew Index, 25 delta risk reversal price, and call skew prices all indicated we were at the highs of the last six months. I wanted to have a positive delta lean on the overall idea, however, given the positive seasonality and presumed technical strength. I focused my attention on the weekly options because I know there is large and growing volume and open interest in these contracts.

Wheat call ratio spread – weekly options

I chose to do a call ratio spread focusing on the fourth week of October. In this example, I bought one of the 940 calls, sold one of the 990 calls and sold one of the 1005 calls. In total, I took in 12 ticks to do this trade, so it is net positive premium and short vega, while still being long delta. The breakeven of this trade is 1067 in the futures vs. the 934 current price or 14% upside from where we are with 25 days until expiration. We would need a move of similar magnitude to what we saw last month to get to the breakeven.

A trader needs to understand, however, that this trade may not carry well especially if there are moves to the upside early in the life of the option spread. We can see from the expected return graph that a move higher early in the trade would lead to negative expected returns. The longer it takes to rally, the better the trade would do. Given we are net short options, again because the cost of these options is so high relative to other strikes and to its own history, we should expect that large moves have a risk for us. However, the longer it takes to make a move, the trader can benefit by earning theta while still being long delta. If for some reason futures head lower, since we took in premium, we would be protected and can just take that premium in. This is a way for a trader to add leverage to a current bullish position or perhaps a capital-efficient way to add a long delta trade perhaps when the view is that we may move higher but not to yearly highs. 

Figure 14: Expected return for a Wheat call ratio spread

Class III Milk options - another look

I also wanted to revisit some ideas I have had the past two months. In August, we talked about Class III Milk options given the rapidly increasing average daily volume and open interest. Implied volatility was high, but we saw scope for a move higher in the futures. We chose to express the view by selling one Sept 20.5 call to buy three Sept 22.5 calls. The logic was if we got a big move higher, the leverage from the idea would kick in and we could take advantage of these long deltas. If nothing happened, we still would take in some premium (about 12 ticks). The risk was a slow drift higher above the 20.50 strike but below the 22.50 strike.

If we look at what happened, there was a move higher not quite to 21 when the piece first came out. Subsequently, the futures drifted back lower before settling at 19.84 at maturity. A trader who followed the idea and held it to maturity would have collected a small amount of premium from the idea. While the big move higher did not materialize, given the way we structured the spread, there was still an opportunity to make some money while not really being at any risk to have to manage the trade after initiation. 

Figure 15: Class III Milk September futures price chart

Class III Milk options continue to set records in terms of average daily volume and open interest. There is growing liquidity in the product, and this is a space that traders should continue to look for opportunities.

Figure 16: Milk options average daily volume and open interest

Feeder Cattle straddle – another look

In September, we looked to the Feeder Cattle market. This continued to be an area of intense interest during the month, as we can see from the first image that volume was up 73% year over year. A month ago, we thought implied volatility relative to historical volatility looked inexpensive. There was negative seasonality but strong potential drivers to the market, particularly from input costs and trader demand. Price trends were also quite positive on a YTD basis. We thought the best way to position for this indecision or difference of opinion and market price was to go long an Oct 185 straddle, paying 6.90 on a 12.35 implied volatility. We can see that, subsequently, the October futures price broke down from the 185 level at the time to 174 currently. A trader who bought the straddle at 6.90 had a breakeven of 178.10 and so we are below that level now. If no delta hedging has been done up until this point, a trader is currently sitting in some profit.

Figure 17: October Feeder Cattle futures daily price chart

Another way to look at whether the idea was successful is to assume the trader may have delta-hedged the position. After all, it was predicated on indecision and lower implied relative to historical. For a delta-hedged straddle, the right way to assess is not to look at the breakeven but to compare both the current level of implied volatility to that at the time of trade, as well as look at the current trailing historical volatility to the time of trade. We bought the straddle on a 12.30 implied volatility. The current implied volatility is 13.58 and the trailing historical volatility is 14.16. On both bases, whether the trader has traded out of the straddle, or held it and delta-hedged, there should be profit on this idea.

Figure 18: October Feeder Cattle implied vs. historical volatility

I don’t bring up these examples to say how great we have done. Not at all. Every trader should constantly and consistently do an attribution on their trades and ideas to see what has been done well and what has not. In the latter example, I want to show that there were several ways to profit from the idea: 1. Breakeven trade 2. Selling out of straddle on a higher implied volatility 3. Delta hedging the straddle and benefiting from higher historical volatility than expected. On the earlier Class III example, I wanted to show that if we structure an idea properly, even when we are wrong on direction, which we were that month, we can still build in the possibility of profit. It may not be as much as if we were right, but it can be a nice consolation prize.

Options can be very useful tools in a trader’s toolkit. If a trader thinks through the potential risks and opportunities and looks at implementing the ideas taking advantage of where there may be pricing inefficiencies, the trader can have success. Importantly, we want to constantly assess how we have done, what we have done well, and what we have not done well, to find ways we can improve our process.

Good luck trading.

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