Executive summary

With summer approaching, food prices increasing, and production decreasing, Agricultural markets may be in for a turbulent ride. In this issue, Rich explores opportunities in these markets: 

  • Lean Hog call calendar butterfly
  • Corn call butterfly

You are probably sick of hearing someone talk about it by now. You know what I am talking about. No, it isn’t COVID (well, it kind of is). I am talking about inflation. I am old enough to remember when Jay Powell said inflation was transitory last year. Doh! This year, we are expecting growth to pull inflation lower. However, the fire the central banks are playing with is that inflation isn’t a number, it is a mindset. When you and I think prices are going to keep going higher, we are going to ask for a raise. If we can’t get a raise, then economists would tell you the substitution effects kick in, and we will delay current spending in favor of current saving with an eye toward future spending. The bulk of the discussion in the media and markets has been on the price of energy. Maybe this is all part of the climate debate. Who really knows? The move higher in energy matters. However, we are also seeing record food price levels in the global economy, as the data from the UN shows. 

Figure 1: UN Food Prices

This is across all food we consider. However, just a couple weeks ago, we were given this market outlook from the USDA:

“Pork/Hogs: The Quarterly Hogs and Pigs report indicated reductions in almost all reported categories that determine 2022 production. Commercial pork production is reduced about 250 million pounds to 27.1 billion pounds, about 2 percent lower than production last year. Pork exports for 2022 are reduced to 6.595 billion pounds, 6.2 percent lower than a year ago, on weak demand from key importing regions.”

Source: USDA Economic Research Service Market Outlook 4/14/22

I thought the cure for high prices was high prices? When it comes to commodities like lean hogs, shouldn’t high prices attract more production and not less production? Maybe some of the substitution effect is creeping in, at least regarding exports.

Maybe there is a COVID reason. In a report issued in December 2021 on retail pork prices, “economists with Iowa State University, North Carolina State University, and the National Pork Producers Council found that pork prices, not industry profits, are rising. Prices are rising due to increased transportation costs, supply bottlenecks and delays, and increased labor costs throughout the pork chain. Those factors, said Iowa State's Dermot Hayes, NC State's Barry Goodwin, and NPPC's Holly Cook, were either caused or exacerbated by the COVID-19 pandemic. Other factors that have affected prices up and down the pork chain over the past 18 months, the report noted, include a 2.5% loss in pork packing capacity that resulted from a federal court order stopping faster harvesting line speeds, higher energy costs, rising feed costs and, most importantly, a shortage of workers, which has hindered productivity and caused wages to increase.”

Source: hogfarmer.com

So, it isn’t a recent phenomenon that there is an expectation of higher prices for hogs. The bottlenecks, higher labor costs, and increased fuel prices are still a factor. Now, we also have feed costs going up. It would seem futures market participants have been worried about this accumulation of factors for several months. In Figure 2, we can see from the skew in hogs for the last seven months that there has been a preference for upside strikes. The purple line is showing Skew for Lean Hogs going from -9 to +1 over the last six months. The Skew Index looks at Up Side skew (out-of-the money calls) minus Down Side skew (out-of-the money puts), so a more positive number shows strength to upside volatility.

Figure 2: CME Group Volatility Index (CVOL) skew for Lean Hogs

As I am not an expert in this product, I also want to see if there is some seasonality to prices for hogs. A quick view of the percent change in the front month futures for the last 10 years show there is some upside bias to prices in the spring followed by a downside bias to futures prices in the later summer.

Figure 3: Lean Hog futures price over 10 years

Now my interest is somewhat piqued. That starts to sound like a calendar spread could line up. There is some expectation of higher prices, but a lot of this news has been in the market for some time, even if the USDA suggests it might continue. A look at the term structure of volatility shows that implied volatility is certainly elevated for the July and August period relative to the months around it.  That is also a period of peak futures prices if you look at the term structure of the futures.

Figure 4: Lean Hogs Volatilty Term Structure

Lean Hog Calendar Call Butterfly example

Because the implied volatility is elevated and the call volatility is particularly elevated per the skew, a call calendar butterfly makes more sense here than a put calendar butterfly. To do this, a trader could look to sell the August 108 calls, which are priced on a 32 implied volatility in QuikStrike’s Spreadbuilder. To limit exposure to the delta risk, one could cover that by buying a June 103 call and a December 90 call.  The implied volatility for each of those is 27 and 29. The position is selling the highest strike calls (because of the futures term structure) at the highest implied volatility (because of the volatility term structure) for a period when seasonality suggests there has historically been a good chance of downside in prices. As the Spreadbuilder shows, the position took in 2.41 to do this spread, but right now is relatively neutral in gamma and vega. A trader would need to understand there is risk once the June calls expire. At that time, a trader might want to cover the entire spread, if the futures have moved such that the spread can be covered and a profit locked in. Instead, a trader may want to buy July calls to cover their risk for the next month.

Figure 5: Lean Hog Calendar Call Butterfly

As we can see from the expected return graph (Figure 6), until June expiration, this calendar call butterfly should behave somewhat like a backspread or a long straddle position. Basis risk exists because of the futures spread component as well as the implied volatility term structure. However, if historical seasonality prevails, particularly in a market where many may be thinking the same thing, a trader could in fact benefit from this market pricing.

Figure 6: Lean Hog Calendar Call Butterfly expected return

Corn Butterfly

For anyone that follows agricultural markets for a living, the bigger story of 2022 may be the crops – corn, soybeans, and wheat. We have meaningful reductions in global supply as well as materially higher fertilizer costs this year. These are topics we covered in the March 8 Excell with Options report, and the problems are still with us as we enter the summer planting season. I can see the planting well underway on my weekly drives down I-57 from Chicago to Champaign. Yes, there has been some pretty wet weather which has surely caused some difficulty and frustration among the farmers, but the incentive is there with corn prices at 10-year highs for the continuous front month contract.

Figure 7: Corn 10-year futures prices

The futures market has not been the only place to see action in 2022. Starting in 2022, standard December options had a little over 100K contracts outstanding, 70K being calls and 40k being puts. At the end of April, close to 700K contracts are outstanding with ~400K being calls and ~285K being puts. A put/call ratio below one represents more calls than puts outstanding; as the ratio approaches one, more put positions are being established vs. calls. Not only has the volume in the December options market gone up six-fold, but the relative demand for puts over calls has also gone higher. Whether this is speculative trading or hedging underlying positions, it is hard to tell. Clearly there has been some strong demand for the insurance that options, specifically puts, can provide to the end-user.

Figure 8: Examining put/call ratio of Dec Corn option positions

Overlaying December futures price with the put/call ratio can help show where market participants are establishing option positions given price movements. While the pattern or relationship may not have been as clear in the first two months of the year, over the last year, higher Corn futures prices are seeing a higher demand for downside options.

Figure 9: How futures price relates to put/call ratio of Dec Corn option positions

In the last month, there is incremental news of demand for corn coming from a very different source. According to NPR on April 12: “On a day when inflation hit its highest monthly figure in 40 years, President Biden announced Tuesday that his administration will temporarily allow E15 gasoline — gasoline that uses a 15% ethanol blend that is usually banned from sale from June to September — to be sold this summer, a measure intended to help ease gas prices.”  If we step back, we again can see that this year, we not only have seen a reduction in supply and an increase in fertilizer costs, of which corn demand a lot of fertilizer, we also now see a source of demand that was unforeseen a few months ago. In addition, this E15 mandate ties the price of corn more closely to the price of oil as well, because it can be used to mix.

Figure 10: Corn Energy Correlation

Despite the move higher in futures to 10-year highs, with demand for options up six-fold, a look at CVOL shows us that Corn implied volatility, at a shade under 33, is toward the low end of where it has been over the last 12 months. However, this can be a bit misleading, as the breakevens for the September 730 straddle are 617 and 842. This range is quite large relative the movements of the last several years.

Figure 11: CVOL One-Year Agriculture volatility

Instead, a trader may want to take advantage of the reasonable at-the-money implied volatility but elevated demand for options in general, combined with futures prices being at a 10-year high, and put on a call butterfly in case this new demand takes us into uncharted territory. The market seems well hedged for a pullback based on the put options trading. What if it doesn’t happen? The pushback on same expiration butterflies, which I would agree with, is that it can be like finding a needle in a haystack. I can probably count on one hand the number of times I have gotten the direction correct as well as the optimal settle price. Instead, I have found that asymmetric butterflies, which my colleagues and I used to call split-strike butterflies, might be more beneficial.

The example here is to buy a relatively at-the-money call with a 760 strike. The implied volatility is below 36.  Next, sell two options at the 800 strike, which have over a 37 volatility. Finally, the risk is covered with an 820 strike call. This is the asymmetry I am talking about, with 40 points between my first long call and the guts of the fly, but only 20 points to the next strike.

Figure 12 shows the breakeven price of the spread is about 768, which is below the highs for the year in the September futures contract. Above that breakeven, the profitability continues to move higher, with a maximum profitability at expiration at the 800 level.  In fact, the max profit relative to the max loss is 4 to 1 in this spread, which is very desirable. We can also see that the max loss comes really in the last month of the spread as the options suffer time decay. A trader then could consider stopping themselves out of the trade after about two months, before this max loss is seen. It allows the trader to have on a bullish idea for about two months before making a big decision.

Figure 12: Expected Return Corn Call Butterfly

No trade is perfect. Nothing in life is perfect. It has been an incredibly difficult market to trade this year for all traders. However, sometimes a little creativity can still help you achieve favorable risk-return scenarios which is what a trader should ideally be always looking for. Trying a split-strike butterfly, you might be able to achieve the desired outcomes that your portfolio needs.

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The opinions and statements contained in the commentary on this page do not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs. This content has been produced by [Data Resource Technology]. CME Group has not had any input into the content and neither CME Group nor its affiliates shall be responsible or liable for the same.


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