Executive summary

With the upcoming June 30 USDA acreage report as a potential market catalyst, Rich looks at current price action and comparisons to past weather conditions to build options spreads on corn that could benefit from potential movement in either direction.

Image 1: Climate Prediction Center long-range temperature outlook for the USA

It has been hard to escape discussions about the weather this spring. With the unfortunate wildfires in Canada leading to air quality issues across North America, everyone has a view or opinion about whether the weather patterns we are witnessing are good or bad. Clearly in the ag markets, this is always a topic of intense interest as well. Along this front, it is quite interesting to see the recent Seasonal Temperature Outlook for the country released by the National Weather Service’s Climate Prediction Center.

According to these long-range predictions, most of the country is expected to experience above-average temperatures. However, the Midwest has equal chances of either above or below-average temperatures. 

Image 2: Climate Prediction Center’s seasonal precipitation outlook for the USA

However, of even more interest to me is the precipitation outlook released by the same Climate Prediction Center. Much of the Midwest, Southeast, and East Coast are leaning toward a wetter than average Summer. In fact, Southern Illinois, Indiana, and Ohio are not just leaning above wetter but very likely to be above average. This covers much of the Heartland of the U.S., which produces the most corn.

The Old Farmer’s Almanac is predicting the same, saying that precipitation looks to be on the wet side in the region spanning from the Upper Midwest, down through the Appalachians, and into the Mid Atlantic.

Image 3: Seasonal chart of New Crop Corn futures over the past decade

This matters a great deal, of course, for the corn yield and thus the price of corn. As we can see from the seasonal chart of the front month Corn futures, this year in yellow is tracking very closely to both 2012 and 2013 in terms of price. The outlook for price going forward can vary greatly whether it follows either 2012 or 2013 because those years took decidedly different paths in the back half of the year. The blue line indicates the 2012 drought, and you can see the price spiked at the end of June and continued higher the rest of the year. The next year was quite the opposite, as farmers got rain that year and the price moved sharply lower in July and struggled for the rest of the year. A catalyst in each of these years was the USDA Acreage report which is due out on June 30.

Image 4: University of Nebraska-Lincoln Drought Monitor

So far this year, the USDA corn outlook has not changed that much with increases to both beginning and ending stocks, which has proved to pressure prices a bit this year. We will get updated indications of the planted and harvested area on June 30, which will likely be affected by the current drought-like conditions we are currently experiencing, as well as any temperature impacts because of the fires I discussed before.

According to University of Nebraska-Lincoln, both Illinois and Indiana so far this year are in the midst of D0 or D1 conditions, which are either considered Abnormally Dry or a Moderate Drought. However, Nebraska is experiencing a much harsher spring and has more than half of the state in a condition considered Severe Drought, Extreme Drought, or even Exceptional Drought. 

Image 5: Daily Ichimoku Cloud Chart for the December New Crop Corn futures

We may be seeing the effects of these dry current conditions in the price of corn already. If I pull up a chart of the December New Crop Corn futures, I can see that in the last month, the price has risen sharply and has broken above the cloud. The cloud is the area where over the last few months, the volume has taken place, indicating the area where bulls and bears–buyers and sellers–have positioned themselves. Breaks of the cloud suggest that one of these camps has taken the lead in the debate, and based on this movement, it looks to me like the bulls are starting to get the upper hand.

Notice the trailing white line, however. Those who follow the Ichimoku charts closely know that as the “lagging span.” It is created by plotting the closing prices 26 periods behind the current price. It is done to indicate when we may be seeing a real change in sentiment or opinion. If the futures break above the cloud but the lagging span cannot, then it may be a false breakout.

However, if the lagging span breaks above, it indicates a major change in sentiment in the contract. As we can see here, while the futures are breaking above, the lagging span has yet to begin. Thus, the bears have not yet capitulated and we may still see a battle in the futures markets at the current levels. 

Image 6: December Corn Implied Volatility

As the futures price has risen over the last month, we can see that both implied and historical volatility is also picking up. The implied volatility has been fairly constant at 24 all year long, but in the last month it has risen with futures hitting a level as high as 30–the highest we have seen all year long. It is not just the traders’ expectations of futures volatility that are driving this movement. We can see that the historical volatility experienced in the market, which had collapsed from a high near 30 in February to as low as 10 in May, has also risen in the last month to more than 20. With the big disparity between implied and historical all of May, traders who were short volatility were more than likely experiencing a better environment. However, this move in both implied and historical has closed the spread somewhat giving those on the long side of volatility some hope of better days ahead. 

Image 7: December Corn Options Skew

With the recent movement, we can also see a shift in the preference for calls over puts. As the futures potentially move into uncharted territory, there is some hedging occurring as shown by the premium by out of the money call options relative to both the at the money and the out of the money puts. In fact, the out of the money puts trade at a discount to the at the money options, suggesting to me that if there is a failure on the breakout, and futures head back lower, traders are expecting a move into a more quiet, lower volatility range like we experienced in May.

Thus, one’s directional view of the futures and one’s view of the options market implied volatility appear to be tied at the hip, where if one is bullish on price, they are probably bullish on implied volatility and vice versa. 

Image 8: Long December Corn futures and long a December 590-650 1 by 2 call spread

This creates opportunities for bulls and bears alike. For the bulls, the June 30 USDA Acreage report could further push prices higher, potentially confirming the breakout, and validating that we may already be in a drought that will continue. Tracking the 2012 price action, I think there are opportunities to lever my position based on what the options market is showing. Implied volatilities are above the levels seen all year long, and once we are past the catalyst, may be likely to subside. The skew may not, but I can take advantage of it now.

My favorite way to gain leverage on a directional position I already have on around a catalyst is to use 1 by 2 ratio spreads. I know these are recommended by some as a directional trade on their own. I do not like that myself because I think this opens me up to being “too right” where one gets the direction correct but because the futures price keeps going, I could end up losing money on the ratio spread. Instead, I consider using a 1 by 2 ratio call spread to gain leverage to my long futures position. If I break the combined strategy down to its component parts, it makes more sense to me.

The long futures plus a long 590-650 1 by 2 call spread can also be seen as a long 590-650 call spread and long futures short 650 buy write. The latter idea could be a way for me to enhance my yield on an existing directional view. The former idea could be a way for me to have a low-risk directional trade. Combined, I have the same downside risk as long futures on its own but gains more than they would on long futures alone from 590-650, after which the position is capped. Given the 1 by 2 can be down for a credit since there is positive skew, even if the move is a non-event, I could get this leverage and still make a little money. Again, I must be willing to take the directional long in the first place, but if I do, the options market is giving me the opportunity to get paid a small credit to add leverage to my view. 

Image 9: Long a June 30 525-520 put spread

However, there are likely to be traders that have a very different view. They may be looking at the forecasts from both the Climate Prediction Center and the Old Farmer’s Almanac thinking that while we may be in a bit of a drought currently, we are set to be much wetter than average the rest of the year. If this proves to be the case, the futures price over the course of the year may end up looking like 2013, where we were flat to down small through July, but post the USDA Acreage Report and the ensuing rains, futures prices declined for the rest of the year and ended up down over 37%. These traders would be bearish futures here and focused on the fact the lagging span has not broken on the charts. The bears still have a chance to win this debate in the markets, seeing the current movement as a false breakout and potential failure.

There may be a way to gain short exposure for this particular catalyst with a defined-risk idea. The benefit of using options is to define the risk of an idea. The benefit of using CME Group weekly options is that I can find expirations that occur very close to, if not upon, the catalyst date. For the bearish idea, I consider the CN5M3 weekly options which expire on the day of the event. This provides me with the maximum bang for my buck as an option trader because the theta or time decay will be minimized prior to the event, and the options will essentially become binary payouts on the outcome of that catalyst.

Thinking of binary outcomes, if I want to be short, I could consider a very tight put spread that approximates a binary option on this event. For instance, if I buy these June 30 expiration options, and use a very tight strike differential, I can get essentially a binary reward to risk payout. Using the 525-520 put spread, I would spend 1.32 in premium with a chance to make a maximum of 5.00 (which would be a net gain of 3.68). I am thus getting a structure that potentially pays out 3.68 for 1.32 of risk or 2.8 to 1 payout assuming the futures move at least 5% (525 top strike / 550.5 current futures price).

If futures move higher, I would lose the premium invested but the risk is defined versus a short futures, which has unlimited potential loss. I might consider buying an outright put. For that same 1.32 in premium, I could only buy the 480 puts for the same expiration, which requires almost a 13% move in the futures (480/550.5) to pay out. The binary put spread structure allows me to move the strikes much closer to the current futures price. 

Image 10: Long a June 30 525-520 put spread vs. short a June 30 580-585 call spread

If I’m willing to take a little more risk and want to get an even better potential reward to risk payout, I could consider selling a 580-585 binary call spread to fund the 525-520 binary put spread. The net premium is essentially zero. There is risk in this strategy if the futures price moves higher, but the loss is defined and maximized at 5.00 or the difference between the 580-585 strikes. Unlike the futures, any move from the current 550.50 futures and 580, or 5% move, there is no loss at expiration. Thus, if I want to be short, I still have a better potential payout than short the futures which lose at any price above current. The gain on the downside is maxed at 5.00 as well, but I can size this position considering the maximum I am willing to lose on the call spread and buy the same number of put spreads.

The USDA Acreage Report on June 30 is set up to be a major potential catalyst for the agriculture markets. With current drought-like conditions but rain expected as we move through the summer, there is a wide range of potential outcomes as we can see from history, looking at the 2012 and 2013 years. The options market gives traders the potential to set up profitable trades in either direction, based on their views. In particular, the weekly options that expire on the day of the catalyst allow the trader to customize their position for the day of the event, to potentially reduce the impact of any other “noise” or influences on the position.

It takes some parsing of what is being priced in and how to use that current pricing to build a spread that fits one’s view. Trading options is not without risk, but by using the information and tools provided by CME Group, I can find potential trades that can benefit from movement that I expect to see around major market events.

Good luck trading!

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