Executive summary

Macro factors have impacted all markets in 2022 but few more so than the grains market. We have witnessed the increased demand in customers using options to either implement ideas or hedge portfolios given this increased uncertainty. As a result of this activity, we have seen different markets impacted in different ways. This month, we look at how to take advantage of this potential disparity in pricing in the wheat and corn options markets.

It is the start of the month, which means another monthly summary of activity on the Agricultural products at CME Group. I look forward to this because it gives me a good synopsis of what other traders are doing. This helps me put together the mosaic of what other traders are thinking as well. Of course, I can never know for sure, but the more data I can analyze, and the more corroborating evidence I can find, the more confident I am in my views. 

The past year has been one characterized by dislocations in the energy and food markets. This all began in Q1 and as we are now in the middle of Q4, there seem to be few signs of this changing too much. In fact, over the weekend, I saw this headline from CNN: 

Russia suspends its participation in UN-brokered grain export deal with Ukraine 
By Uliana Pavlova, Sugam Pokharel, Dennis Lapin and Katharina Krebs 

“Russia will suspend its participation in the United Nations-brokered grain export deal with Ukraine after drone attacks on the Crimean city of Sevastopol, the country’s defense ministry announced Saturday.”

With the G20 approaching in the middle of November, one must think that a major topic of conversation among the government leaders will be the cost of food. As we can see below, the UN Food price index is still extremely elevated relative to the last 20 years. With the headlines above, it does not appear relief is in sight just yet. 

Figure 1: Geopolitical risk index

Thus, I was struck by a chart that I saw in the Ag report this month. It compares the skew in Corn options to the skew in Wheat options. The wheat market has been affected more by the events in Europe, and therefore we should expect to see more elevated skew in wheat than corn given it is more impacted by Russia and Ukraine. However, the amount of dislocation does stand out as the Wheat options market is not too far from where it was at the peak of nervousness in March, whereas the Corn options skew is near the cheapest of the past year.

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

We see this in the CVOL for each product as well. Wheat implied volatilities are still very elevated even if off the highs while corn implied volatilities are at the low of 2022. The gap between the two products, with wheat implied volatility double that of corn, is at or near the peak discrepancy for the year.

Figure 3: Weekly options average daily volume and open interest

When I was working at my hedge fund, and I was comparing two securities against each other – a stock vs. a stock, a stock vs. a bond, a commodity vs. a bond – I would always look at correlations. There is no sense in thinking about relative value between two products if they are not well correlated. We can calculate the correlation between products on the CME Group website. When I do that for the grains, I quickly see that corn and wheat are indeed well correlated with a 64% correlation over the last year. If I look over the last five years, it is still well correlated at 58%. This year, it has been more correlated and not less correlated. We do not see this in the relative option prices above.

Figure 4: Correlation of Daily Log Returns of 30-Day (Constant Maturity Future Prices for Major Benchmarks (10/30/21 – 10/30/22)

In fact, looking at the generic first contract for both corn and wheat, we can see the correlation over the last 65 years. While not perfectly correlated as the magnitude of the moves are different, we can see that wheat and corn directionally move together and do not go in opposite directions. As I said, there may be a difference in the magnitude of moves, but not a difference in the direction of the moves. The products move together.

Figure 5: Corn vs. Wheat generic front month the last 60 years

If we quickly look at each product, we can get a sense for what we may think of each one individually. First, I look to the Ichimoku chart, combined with a MACD and RSI analysis for the continuous wheat contract. Over the last year, I can see a series of lower highs building but I also see strong support in the 730-ish area. This leads to a descending triangle pattern developing and we are in the middle of that range. In these types of patterns, we could see a breakout in either direction, however being in the middle of the range, with no apparent directional cues from either the MACD or RSI presents a chart, which might suggest doing nothing until we see that breakout.

Figure 6: Wheat generic front month daily Ichimoku chart

Seasonally, we do not get much of a sense of direction in November. December has historically been a good month for the product, but November has no apparent trend even if it does have a fair number of months with good volatility.

Figure 7: Wheat futures seasonality by month the past 15 years

Looking at the same charts for corn, there appears to be a more interesting chart developing. While there are no strong signals from the MACD or RSI, there appears to be good support for corn at the top of the Ichimoku range, which comes in at current levels.

Figure 8: Corn generic front month daily Ichimoku chart

While November does have some seasonal weakness, December has historically been a more positive month for corn than it has been for wheat. Perhaps this is what some traders see, which may be why we see the support at current prices.

Figure 9: Corn futures seasonality by month the past 15 years

If we look at the relative trade of long corn and short wheat, we can see the current ratio around 0.80 is in line with what we have seen over the last 20 years. Over the last two years we have seen this ratio range from 0.60 to 1.00. A more interesting part of this chart for me is that the ratio has been making a series of higher lows throughout 2022. Does this possibly suggest some upside to the top of the range?

Figure 10: Corn vs. Wheat relative price chart the past 20 years

If we now look at positioning for corn, I like to switch to the Commitment of Traders report. Among the managed money accounts, the net long position has been growing from the lows back in July of this year but is still well off the highs of the year.

Figure 11: Corn COT Report for Managed Money (Futures)

Conversely, managed accounts are short wheat with positions being at the shortest we have seen over the last 12 months. Managed accounts appear to be growing a long in corn and building a short in wheat.

Figure 12: Wheat COT Report for Managed Money (Futures)

For me, I am starting to see a trade develop taking in the information as above. We have two products that are well-correlated and have the same macro (G20) catalyst coming up in a couple of weeks. We see a relative extreme in pricing in the implied volatility market with wheat implied volatilities double corn implied volatilities, at the peak of the year. We see this differential in pricing also show up in the skew market where traders are paying up much more for wheat upside than corn upside, perhaps given the short position in wheat vs. the long in corn.

Traders who are interested in being long corn and short wheat might have a better way of implementing this idea when looking at the options market. For example, using the relative disparity in pricing to sell wheat upside calls and use the premium to buy a multiple of corn upside calls could provide the same exposure with the benefit of leverage to the trade if the directional idea is correct. Let’s dig into this.

We can see in the wheat implied volatilities there is a peak in early 2023 options just below 40.

Figure 13: Wheat options implied volatility term structure

Corn implied volatilities are also upward sloping but the early 2023 implied volatilities are much lower than in wheat as we saw in the CVOL chart earlier.

Figure 14: Corn options implied volatility term structure

I showed the relative skew pricing earlier, but we can see when looking at the 25 delta risk reversal chart that the 60 day risk reversal still has high relative premium for upside even if this has been a little lower in the last month.

Conversely, the same 60-day, 25 delta risk reversal in corn is close to flat, which is near the low of the year.

Figure 15: Corn options 25 delta risk reversal over time

January appears to be the sweet spot for selling wheat implied volatility and for selling upside in wheat. For example, I look to sell a January 900 call, which is 6% above the current future and still below the descending trendline that we saw in the Ichimoku chart. If I sell this option, I am selling a 39.25 implied volatility and taking in 30.78 in premium.

Figure 16: Expected return for short a Wheat Jan 900 call

I then want to buy a similar option in corn. If I look at 6% above the current future in corn, it would be about 727. Instead I buy a 725 call out to January. I only have to pay a 20.94 implied volatility, about half the 39 implied in wheat.  Each unit only costs 8.43, so I am able to buy three of these calls with the premium I took in on the wheat calls and still have money left over.

Figure 17: Expected return for a long Corn Jan 725 call

Of course, we do not know how this will play out. However, we are relying on historical correlations to hold. Correlations this year have been at the highest of the last five years. Visually, we have seen that corn and wheat do not move in opposite directions, they move in the same directions but maybe at different speeds.

Seasonally, we know that corn has potentially more upside than wheat in December and January. On a relative pricing, we know the relative price is in the middle of the range but has been making a series of higher lows. With this idea, a few different scenarios could play out. The first being that both corn and wheat move lower. If this is the case, both options will finish out of the money. A trader would net take in 5.50 if this were to happen. It does not matter where the ratio goes if both move lower.  Second, both corn and wheat move higher and the ratio stays the same, around 0.82.  If wheat gets to our short 900 strike, this would imply corn moving to 738. If that is the case, at expiration, I would be further in the money on the corn calls than the wheat calls and thus see an attractive payout.  Third, both corn and wheat move higher and the ratio goes to the high end of the range (e.g., 0.90). This would suggest that this would be a very attractive trade. Let’s suggest wheat is at 900, this would imply corn at 810 vs. our 725 long. Again, I am long three units of corn and short only one unit of wheat. This would make 255 net.  Fourth, both corn and wheat move higher but the ratio moves toward the lower end of the range at 0.70. This would likely result in a net loss on the trade depending on how much higher the two went. If corn went to 750, I would make 25 x 3 = 75 on our corn calls. However, this would imply wheat at 1071 and I would lose 1071-900 or 171 on the wheat. Net, I would lose 96 on the trade. However, if I was using this in lieu of a futures trade as I suggested, I would have lost on the trade anyway because the ratio moved against me.

It is always incumbent on the trader to look at the relative pricing in the market to find the optimal implementation of their idea. A long 3x corn call vs. short 1x wheat call might be an attractive way to play the upcoming catalysts and positioning in the grains market.

Good luck trading.

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