Veteran institutional trader Rich Excell examines volatility in agricultural markets and explores two ways to approach these markets using grain option strategies.
- Levering a long wheat futures position using a 1x2 ratio spread
- Corn vs soybean relative value spread
This week, I’d like to focus on managing economic risks on agricultural products that may be affected by events in Europe, which include impacts to major exports of certain agricultural (and energy) products and sanctions. While it’s still unknown how this will affect the ability to plant many crops this year, one may expect exports to be much smaller than normal. Not only are most farmers and producers thinking about this now, but everyone who counts food and energy among their essential costs. That is all of us. We have touched on the impact on the oil markets in previous musings. However, it should not be forgotten that natural gas prices are a major component of fertilizer. According to the American Farm Bureau, 60-70% of fertilizer costs are from natural gas, and the price hike of fertilizer prices for farmers might be as much as 30% higher. As you can see in Figure 1 below, courtesy of Vox and International Trade Center, two crops for which CME Group has active futures and options contracts that may be most affected are corn and wheat.
Figure 1: 2020 share of total global exports
Traders may be aware of this supply chain disruption as we see, using CME Groups CVOL product, that implied volatilities for corn, wheat and even soybeans are at 1-year highs.
Figure 2: CVOL Corn/Bean/Wheat Implied Volatility
Markets like this can be very difficult to trade for even the most seasoned traders. In fact, my former boss, who had decades of experience, would often caution us to ‘live to fight another day’ and encourage us to reduce position sizes in this type of market. For platforms that use a Value at Risk (VaR) capital allocation approach, position sizes might have to come lower regardless. VaR calculations use implied volatility as an input to determine the risk of a portfolio. For example, looking at the potential for losses over a 10-day interval with 95% confidence. When implied volatilities move higher, the risk measures increase for all products. If one is told they are allowed to take $XX of risk, this will mean that when implied volatility is high, the number of contracts must be reduced. This is a common allocation technique among levered firms such as prop trading firms and hedge funds.
Wheat Trade Example
Let’s assume a trader that is focused on the wheat market. They are currently long 1 unit of futures risk because they have correctly seen the unfolding situation in Europe. They realize there is 26% of global wheat supplies that may not make it to market (Figure 1). They would like to increase the size of their position because they have momentum on their side and do not see any immediate resolution. However, as we discussed with VaR guidelines, they cannot buy any more futures. They look to the options market to potentially help them get more leverage to their idea. Most traders and investors prefer to buy options because of the limited risk/unlimited potential gain profile. In current market conditions, this has clearly played out as we can see from the CVOL chart above (Figure 2). Looking at the QuikStrike skew levels as measured by calls minus puts (Figure 3), we see that this call skew is the highest in 15 years.
Figure 3: SRW Wheat Implied Volatilty
Digging in more deeply and using the QuikVol 2.0 tool, one can also look at call skew only. This is a measure of call implied volatility relative to the at-the-money implied volatility. So, whether you are comparing to out-of-the money puts or at-the-money options, the out-of-the money call options have historically high implied volatilities.
Figure 4: SRW Wheat Call Skew
One way to lever a long futures position is by using a 1 by 2 ratio call spread. I would not recommend a ratio call spread as a directional idea on its own as I know there are some people that want to do that. However, looking at the risk (Figure 5), if the futures price moves up above the breakeven of the ratio call spread, the position will start to lose money on a 1 to 1 basis. However, these risks are minimized if this strategy is used to leverage an existing futures position. If the market settles above the breakeven level of this strategy, the long future will be called away. This trade may produce greater profit on the move higher without additional risk to the downside in the price of Wheat than currently exists with the existing futures position.
How is this? For example, a trader may buy 1 unit of the 1050 May Wheat calls and sell 2 units of the 1180 May Wheat calls. At current prices, the net premium cost is 1.16. So, if wheat stays the same or moves lower, the position has very limited premium outlay. However, if prices move above 1050, the position profits. The maximum profit is when futures prices are at the short strike of 1180. However, even if the market moves above that level, because of the existing long future, the position will still see those maximum gains. A trader could consider a similar ratio put spread if they prefer to be short futures. I am not trying to give anyone a directional idea. I am suggesting that a way to capitalize on high implied volatility and high call skew to leverage an existing long future is to look at 1 by 2 ratio call spreads.
Figure 5: 1x2 ratio call spread
Corn vs. Soybeans spread example
If I stay on the same theme of Ukrainian conflict disrupting futures prices, the next trade example is in corn vs. soybeans. This is a classic relationship, that I am familiar with in Illinois, because farmers will look to make a choice between these two crops when planting season is upon us. In the next month or so, we will get a WASDE report on March 9 and the planting intentions on March 31. These are catalysts that show how farmers are potentially deciding between the two crops. Using QuikStrike’s Historical Correlation Tool, one can see that over the last 5 years there is over a 60% correlation between corn and soybeans.
Figure 6: Corn vs Soybean correlation
Both have also been impacted by the move to alternative energy as corn is used in ethanol and soybean oil is used in biodiesel. These trends will potentially continue into the near future. However, as I suggested, I am focused on the potential disruption coming from Europe. Again, referring to the chart in Figure 1 from the international trade center, Ukraine is responsible for 13% of global corn exports but none of the global soybean exports. Perhaps you are a trader that has seen the two futures moving largely in tandem over the past year. In fact, looking at a graph of relative prices for the past year (Figure 7), one can see that the current ratio of corn to soybeans stands at 2.36 and has been in a range of 2 to 2.6. Additionally, corn is more fertilizer intensive than soybeans and one should consider that prices of corn may have more upside than soybeans on a relative basis.
Figure 7: Corn/Soybean relative pricing ratio
Looking at the QuikMarket tool, the implied volatility of Corn is about 41 while it is about 28 for soybeans.
Figure 8: QuikMarket Agriculture Volatility Dashboard
Corn implied volatility of 41 is also above historical volatility of 38.
Figure 9: CVOL Corn Volatility
While soybeans implied vol of 28 is in line with the realized volatility.
Figure 10: CVOL Soybean Volatility
Putting this all together, there may be more relative upside in the price of corn vs. soybeans given the event catalysts, as mentioned, and the price performance of the past year. From a volatility perspective, one may feel that corn implied volatility is more expensive than soybean implied volatility relative to its own implied volatility history (Figures 9 & 10), relative to its own realized volatility, and in absolute terms relative to soybean volatility. One possible action a trader may take to put this into a spread trade is to sell 1 put on the Corn June 645 put and buy 1 put on the Soybean June 1500 puts (Figure 11). In this trade, a trader can get short the spread at 2.32 (645/1500) which is at the low end of the last year’s range. The premium paid for the soybean put is 1.71% of notional (25.62/1500) whereas it is 4.3% of notional for corn (27.87/645). You can see that you are buying the cheaper option. In addition, the corn put is 5.1% out of the money (645/ 680.5 futures price), whereas the soybean put is 7.9% out of the money (1500 / 1628.25 futures price). While the option the trader is buying is more out of the money, they are getting into the relative spread price at an attractive level. If nothing happens and both options expire out of the money, they will collect 27.87-25.62 = 2.25. If both futures move lower, around the near-term catalysts, the trader may still see profits. For instance, if corn moves down to 600, they will lose 45 on the short corn puts. However, if soybeans move lower and the relative ratio between the two moves to 02.25 or the middle of the range, that would imply soybeans of 600/.45 of 1348. They would be up 152 on the soybean puts. If the relative price moved to 2 (the relative highs of the last year), soybeans would be at 1200 and they would have bigger gains (1500-1200 = 300). Soybeans would have to move back to the 1-year relative high of 2.63 for them to lose money on the long puts while losing on your short puts. This is possible of course, but many things would have to go wrong.
Figure 11: Soybean (OZS) 1500 Put (on left) and Corn (OZC) 645 Put (on right)
Both ideas this week, take options usage to a bit of a new level, a more sophisticated level. However, the ideas are developed with fundamental drivers, with catalysts, and with a statistical backing from the analysis traders can do using QuikStrike. These ideas may not fit one’s current fundamental or technical view. However, my hope is that these ideas help you to think of what may be possible in using options to express a more nuanced view.
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