"Think big, think positive, never show any sign of weakness. Always go for the throat. Buy low, sell high. Fear? That's the other guy's problem. Nothing you have ever experienced will prepare you for the absolute carnage you are about to witness." – Louis Winthorpe III
When I started my career on Wall Street, I had already seen many of the movies about the industry. However, as part of the training program at O’Connor & Associates, a company known for its top-level training in markets and derivatives products, we had to watch the movie “Trading Places.” Previously, I saw it as the comedy it was, with some commentary on societal issues. However, when I watched it via the OCA training program, I saw the commentary it had on the trading business, on behavioral finance, and on the mindset it takes to be a great trader. You see, in 1983 when the movie came out, there weren’t too many people on Wall Street speaking about behavioral finance. However, throughout the movie one gets some nuggets that are quite salient.
This year, we are in a bull market for agricultural commodities. Because of global supply constraints, potential climate issues, and the desire to hedge out inflation risks, the agricultural commodity market has been the focus. Not just for the experienced veteran traders who always watch it, or for the end-users whose livelihood depends on it, it has been a market that investors of all types – asset owners hedging inflation, macro funds looking to speculate on the trend – have watched all year long. These funds know that crop prices affect the UN Food Price Index, which in turn drives CPI inflation. Figure 1 shows the three over the last 15 years. One can see that they tend to move together. The CROP Index is a geometric average of corn, wheat, and soybean futures. It has been tied to both measures.
Figure 1: Food prices driving inflation
This potentially matters even more in a year like 2022, when around the developed world central banks are looking to fight inflation. For the past 30 to 40 years, market participants have been groomed to understand it is growth drivers, and not inflation, that drives rate moves. In a multi-decade period of declining inflation, this has made sense. However, the last two years have shown that it is now inflation, and not the growth outlook, that is driving rates. Figure 2 shows that the growth outlook, as measured by the year-over-year change in ISM, has been falling precipitously. Yet, Fed Funds and the 10 Year Yield have moved higher because inflation has moved markedly higher. As we saw in Figure 1, it is food prices as a primary driver. Food is not the only driver, but it is tied. As a result, asset owners and asset managers will look to the agriculture market as a place to hedge or speculate on inflation.
Figure 2: Inflation, not growth, is driving rate changes
All of this has happened before. We really have gotten what has proven to be the largest catalyst in the market the last several years. Looking at CME Group data, the last six years have seen a much larger than usual – double if not triple – move from the acreage report. This is when only those who are closest to the market have been involved. This speaks volumes. This year, we have ‘tourists’ in the markets too. Should we expect even larger moves than normal? It is hard to say, but it would not seem to suggest the moves are less than normal when we get the acreage report on June 30.
Figure 3: Acreage Report Moves versus All Other Trading Days
Drilling in some to the moves over the last six years, one can see that last year had quite the outsized move. Perhaps, coincidentally, this was a year in which these agriculture tourists had already gotten involved. As a result, wheat and corn may be two products where one might want to look for option positions ahead of the June 30 acreage report.
Figure 4: Acreage report moves over the last six years
As Billy Ray Valentine and Louis Winthorpe III start to think about how to trade the next crop report, and we will assume there is no Clarence Beeks in this remake, they might be drawn to the Wheat and Corn options markets to look for ideas. These have been the biggest movers on the news lately, there may be many people in and outside the agriculture industry watching it, and it is a big potential driver of CPI inflation and interest rates going forward. When starting to look for trades in a product, whether one that is new to you or one you trade frequently, you should start with a bigger picture view of where we currently stand. One of the best ways to do this is the CME Group Volatility Index (CVOL). From Figure 5, if we are focusing on wheat and corn, the implied volatility in wheat is below the average of the last six months. In addition, the skew is fairly steep, favoring the upside. The same is true with corn in terms of skew, where there is a pretty big skew toward the upside. However, corn implied volatility overall looks elevated relative to the levels we have seen the last six months. Therefore, both products have skew favoring the upside, but wheat implied looks relatively low while corn implied volatility looks relatively expensive.
Figure 5: CVOL for Agriculture products
The next step I would take is to look at the term structure of implied volatility to see what is priced in for events near and far. For both products, near term implied volatility is much higher than the further out implied volatility. The market sees the same data on the moves around the acreage report that was highlighted above and is pricing accordingly. This means a trader probably needs to be more creative in expressing their ideas.
Figure 6 & 7: Wheat and Corn term structure of implied volatility
Example One: Corn options
I showed above that the geometric average of corn, wheat, and soybean prices have been moving higher in almost a straight shot for the better part of two years. How does it look if we consider the products individually? Looking at a daily chart of the generic front month Corn future, on a daily basis, we can see that some weakness may be emerging. Not only has the priced moved below the Ichimoku Cloud level, but the lagging span in red is now entering the cloud. In addition, the MACD is rolling over. This signal may not be strong enough to enter a trade on its own but given there is a potential catalyst in the market in the next week, the daily chart is looking fragile as we enter this catalyst.
Figure 8: Generic front month corn future daily Ichimoku Cloud chart
In trying to find corroborating evidence, I also look at the same chart on a weekly basis to see if there are any signs of weakness, or if the above chart is just some potential cyclical weakness within a stronger secular trend. While the uptrend does potentially appear to be intact, the weekly MACD is turning lower giving a yellow warning flag.
Figure 9: Weekly Ichimoku Cloud chart for the generic front month corn
There is a potential for corn to look weak technically. There is a large potential move priced into the Corn option market and implied volatility is quite high. Finally, skew is quite elevated, favoring the upside. So, whether one is looking to hedge a long Corn futures position, or looking to play a potential downside move, it looks like the preferred way to consider this idea is to look to sell upside options in some way and use the proceeds to buy downside options. That way, one is not buying options on net with implied options elevated. In addition, one is not selling options on net when there is a large potential move. However, one is potentially taking some directional risk – either by choice because of weak technical patterns, or because they might want to hedge a long position – and elects to use elevated levels of upside skew to do so.
In fact, if we look at the front month 25 delta risk reversal over the last 10 years, we can see that it tends to peak each year at about this time and around this catalyst.
Figure 10: Corn 25 delta risk reversals
Whether one is long the underlying and looking to hedge, or looking for a directional downside view, they might be nervous about selling upside in corn options. After all, if we break above the old high on this catalyst, there is no telling how high the market could go. With that said, if the catalyst is negative and the move lower confirms the weakening technical pattern, there is potentially meaningful downside. Since the upside skew is quite steep, we can maximize this to create a structure in which there is some risk on a move higher, but that risk is capped. However, the benefit is there is unlimited potential gain – either as a hedge or as a directional view – on a move lower. For relatively zero cost, we can sell a September 685-715 call spread, being willing to be short on a move above 685, but stopped out at 715, and use the proceeds to buy a 585 put in the same expiration. As of June 22, 2022, the future is roughly at 655.
Figure 11: Selling a corn call spread to buy a put
Example Two: Long volatility and convexity on Wheat futures and options
You know the set-up as I laid it out above. If we look at the generic front month Wheat future, it is already breaking down even more than corn. The lagging span in red has moved below the Ichimoku Cloud. This is a very negative signal in the short-term.
Figure 12: Daily Ichimoku Cloud chart for generic front month wheat
Looking to the weekly chart, it is equally as negative. The MACD is moving lower and there is the potential for a move from 993 (where we are now) to the cloud support at 781.
Figure 13: Weekly Ichimoku Cloud for generic front month wheat
This is the set-up in wheat. In the past six years, it has had the biggest moves of the Ag products from the acreage report and the implied volatility is lower than average for the last six months. Finally, the technicals are starting to break down. This looks like the time to own some downside on wheat. One might choose to do this to either hedge an existing long that they are getting nervous about. One might also consider this if they are short Wheat futures and want to swap into Wheat options to gain more leverage on a move lower.
The risk on this idea is the premium paid. However, this may be a risk worth taking because the product has historically had large moves on the acreage report. These large moves are not priced into the futures. Looking at an August 900 put, we would have to pay just over 22 cents, for a break even just above 878. If the product starts to move lower, there is potentially a considerable risk to the downside. You would risk the premium if wrong, however, if you are converting short futures into long puts (for leverage), the premium could potentially be the same as any stop-loss one might employ. In addition, if hedging, this is potentially an attractive source of insurance around an event that has moved the product.
Figure 14: Long an August 900 put on wheat
As Louis Winthorpe III highlighted in the beginning quote things can change quickly in the Ag market. It's important to stay informed and be aware of your options.
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