In this issue of Excell with Options, Rich uses a short put vs. long new crop call spread to express a view around the Prospective Plantings report on March 31.
Food prices have been on top of mind for all traders and all consumers for the better part of two years now. There is probably not a person you speak to that has not made some sort of reference to their “basket of goods” having gone up in price since Covid-19. In fact, the UN Food Price Index hit an all-time high in March of 2022.
However, since that peak, prices have been descending for a year now. In fact, on February 3, the UN published a story commenting on how much the food price index has fallen:
“The FAO food price index fell 17.9 per cent below its all-time peak, reached in March 2022 following Russia’s full-scale invasion of Ukraine.
The downward pricing trend was helped in part by a pivotal agreement signed in July to unblock Ukraine grain exports amid the ongoing war.”
Image 1: UN Food Price Index vs. an average of corn, soybeans, and wheat
If I take the chart above and add the year-over-year change in CPI, you can see a big driver of the CPI over this same period has come from the move in the food price index. Thus, this falling price does have implications for not just consumer and agricultural traders, but also central bank officials and rates traders. One might surmise that the upcoming planting intentions report at the end of March will have eyes from many markets across the globe glued to it.
Image 2: UN Food, Ag futures, and CPI
When I think of the drivers for this planting intentions report, I first think about the weather.
The chart below shows the total precipitation across the U.S. in the last week of February. We can see on the left-hand side of the chart the high levels of precipitation in California, however we can also see that in parts of Illinois, Indiana, and Wisconsin there has been precipitation present too.
Image 3: Total precipitation in the U.S. the last week of February
However, the USDA also puts out the monthly drought outlook. In spite of the precipitation that we have received in the last week of February, drought still persists in many parts of the country. Fortunately, in the Midwest it looks like there is no drought at all, which will likely impact corn and soybeans intentions.
Image 4: Monthly drought monitor
What about temperatures? In the same report, the USDA highlighted the temperature anomalies across the country, and we can see across the Midwest and East Coast, temperatures have been unseasonably warm. On the West Coast, we have seen the opposite with unseasonably cold weather. This makes it hard to think about what might be occurring with the weather across the country. Can anyone predict it?
Image 5: Temperature anomalies
There appears to me to be a good deal of uncertainty as to what the landscape may look like in terms of temperature and precipitation. If other traders feel this same level of uncertainty, it could potentially mean that there will be even more volatility than normal around the March 31 crop report. Thinking of this, I read this piece from CME Group on the Prospective Plantings and new crop markets:
Recent Prospective Plantings Rallied New Crop Markets
Prospective Plantings is widely regarded as one of the most impactful USDA reports released throughout the year because it provides an early meaningful indication of the new crop year’s acreage. Reporting on the prior year’s harvest, though notable, is viewed as a secondary function of the report. As such, the report is particularly powerful with respect to new crop instruments December Corn and November Soybeans.
In both 2021 and 2022, market expectation overshot the reports’ acreage significantly, sending Corn futures limit up on both release dates when the reports’ numbers fell short of polling. Entering the March 31, 2021, Prospective Plantings report, the market had baked in the expectation of 931 million acres, overestimating the report’s 91.144 million acres by 1.856 million acres. December 2021 (new crop) Corn futures settled at limit, 25 cents above the day’s opening price, on March 31, 2021. The report marked the beginning of a price rally in Corn that lasted until May.
1 Bloomberg PPLNCORN Index median estimate
This report contained graphical representations of the movements in Corn futures during both of the preceding two years following the announcement on March 31. You can see that in each of the last two years, we saw volatility on the day of the report followed by a steady move higher in Corn futures.
Image 6: Corn futures 2021 and 2022
It wasn’t just the December future that moved but also the May-December spread that narrowed as December futures rallied more than the May futures. On the left you can see the May-December spread and on the right you can see the move that happened in 2022.
Image 7: May-December Corn future spread in 2023 and 2022
Here I look at a technical picture of the May-December spread. We can see in this picture that the lagging span (26 days prior) is bouncing from the cloud support while the leading span on the right has held closely to the cloud support and is moving back higher into the cloud. In the middle panel, the momentum of the spread is turning back higher. In the bottom panel, we can see the RSI bounced off the lowest level in six months and is also moving higher. Spread traders may see a bullish set-up here.
Image 8: Corn May-Dec spread in Ichimoku Chart
Turning to the options markets, I look at the straddle run for weekly options that I can see from CME Group. This includes New Crop Weekly options, which launched on January 23 of this year. New Crop Weekly options build on the success of Short-Dated New Crop options and combine attributes of short-dated and weekly options, offering new crop exposure at an even shorter duration.
We can see that new crop corn is trading at a discount to old crop corn and has been for some time. Perhaps this presents an opportunity in the options market.
Image 9: Weekly option straddle run for various Ag options
As I pull my thoughts together, there are a few things I want to focus on:
- There is reason to believe volatility will pick up around the March 31 Prospective Plantings report given the history of this report as well as the uncertainty surrounding recent weather patterns.
- There is reason to believe the December future might see another rally as it has each of the past two years.
- There is reason to think the May vs. December spread could also widen, with May futures moving higher than December futures.
- We see new crop options have been less expensive than the standard weekly corn options.
How can I combine this into one spread? I went to the QuikStrike Spread Builder to play with ideas. I kept coming back to wanting to neutralize my cost while still expressing a long delta idea. The idea I settled on was buying a New Crop Weekly CN5H3 option that expires on the day of the crop report and will therefore capture the news on that day. I chose to buy a 590 call, which is a 40 delta compared to the 569 December future price. The implied volatility was about 15.5. I wanted to neutralize the cost, so I looked to sell a ZC5H3 put strike at 615 that settles into the May future, which is at an implied of about 21. As I recall I think the May future can widen relative to December. I get the benefit of the volatility differential; I benefit if the May-December spread widens and I benefit if December itself moves higher. You can see the expected return here. Because of the volatility difference and the futures difference, I am able to buy two times the number of calls to gain more exposure and still stay premium neutral.
Image 10: Short a ZC5H3 615 put vs. Long 2x a CN5H3 590 call
This is not for the faint of heart. This spread is long deltas from both options I have chosen as well as long basis risk between May and December. I am actively selected to take those risks because I think I am able to enter them at attractive levels. However, this type of idea requires a good amount of risk management around the event on March 31. However, because of the flexibility that CME Group weekly options afford a trader, combined with the ability to see the differences the market assigns to new crop vs. standard corn contracts, a trader can fine-tune their ideas to find ideas that have a leverage to the view they wish to express.
You can see from these Greeks of the spread below the idea actually takes in a small amount of premium though it does have a negative theta because we are long two times the number of options. The spread is long gamma and vega for the event where we expect volatility. Thus, the risks of the spread fit the views we sought to express.
Image 11: Option Greeks for the short put long 2 call spread
Perhaps even better than an analysis of the Greeks is the scenario analysis function that we see in QuikStrike. This allows us to see what will happen to the P&L of each option based on the move of each underlying individually as well as the spread in total. This will help me anticipate what happens if both futures move up or down and the May-December basis changes as well. I will see my P&L as well as how my Greeks change. It is a powerful tool to help us manage the risk of a complicated spread.
The products and tools at CME Group help a trader more directly express their views as well as manage the risk after execution. This is powerful especially for how traders may only get involved around particular events.
Good luck trading!
Image 12: Scenario analysis of spread
New Crop Weekly options
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