In this week’s edition of Commodities Corner in Barron’s Financial Weekly, Wall Street Journal writer Owen Fletcher lays out a pretty convincing argument as to why corn prices may not rally this spring/summer, despite the fact that they have showed a tendency to do so many times in the past. And by early indications, he may be on to something. Historically corn has been one of the best commodities to hold a long position in during the month of February. But this year, corn futures opened the month of February with ten – count them – ten consecutive days of price decline. So perhaps “this ain’t the year.”
Still, there are a few intriguing caveats.
1) The fact remains that corn has demonstrated a strong seasonal tendency to advance during late winter into early spring/summer.
2) The implied volatility of corn futures options has also displayed a strong tendency to spike sometime within the late winter into early spring/summer time period, and current IV is at an extremely low level.
3) Options afford alert traders the potential to take advantage of opportunities and situations that they normally might not consider.
So let’s go off the beaten path (i.e., into corn futures and options) this week and discuss a way to put together certain tendencies in order to create a relatively low dollar risk position that has better than average upside potential.
Does this sound like a good time, or what?!
All Things Corn
Price: In the Midwest - where the majority of corn is grown (and where the majority of the population wonder six months of the year why the heck we live here in the first place, but I digress) - corn gets planted in late winter and early spring and is then harvested in late summer. As such, the time when the corn crop is most in doubt is – you guessed it – late winter into spring and early summer. That’s because while there are no seeds in the ground – or if spring weather (too much or not enough precipitation) or summer weather (drought) cause problems, during this time no one knows for sure how good the crop will be this time around. This explains why corn has a showed tendency to rise during this time period.
If growing season goes poorly, supply is lower thus prices will rise. Hence a lot of corn futures buying goes on during this time frame as farmers, commercial and speculators hedge their bets.
All that being said, it should be pointed out that weather and farming prognosticators have gotten pretty good in recent years in forecasting whether growing season will be:
-Good for the corn harvest (and bad for corn prices)
-Bad for the corn harvest (and good for corn prices)
So when Mr. Fletcher writes that a bumper crop might be in store for 2013, it suggests that the most simple approach – i.e., buying corn futures – is maybe not such a great idea this time around.
Still, for the record Figure 1 displays the dollar gain generated since 1979 by holding a long position of one corn futures contract from the close on the last trading day of January through the close on the 13th trading day of June.
Figure 1 – Gain achieved holding long one corn futures contract end of January through June Trading Day 13 (1979-2013)
In a nutshell, this period has witnessed a net gain 22 times, or 63% of the time. Obviously not a sure thing, but definitely a “tendency”.
Corn Option Implied Volatility: Figure 2 displays implied volatility for corn options over the past 999 trading days. Just as price often spikes during the spring, corn option volatility has also shown a tendency to spike at least temporarily somewhere along the way between February and June. These times are noted by green arrows.
Of equal importance, note at the far right hand side that corn option volatility is at its lowest level in years. As option traders we may be able to use this to our advantage.
Figure 2 – Corn option implied volatility, a) often spikes during spring season, and b) is at an extremely low level historically speaking
So let’s assume that we take the aforementioned article at face value (i.e., it may not be a great year for corn prices). So based on this we rule out buying corn futures. Still, let’s say that based on historical price and volatility tendencies and the fact that IV for corn options is presently very low, let’s assume that we still want to have a position that can make money if corn does surprise to the upside, even if only temporarily. Working with this scenario let’s now take a look at how to craft a position in corn options to take advantage of this situation.
A Bullish Butterfly Spread
George Fontanills, the late co-founder of Optionetics was widely known to be fond of an option strategy known as a “butterfly” spread. A lesser known strategy that he taught often was to turn a butterfly spread – essentially a neutral position – into a directional trade by buying a few more calls (if bullish) or puts (if bearish), in order to give the position “explosive potential.” This is a good choice to consider now in corn options for several reasons that I will detail in a moment.
In Figures 3 and 4 you see the setup for a long butterfly spread using July corn options. The trade involves:
Figure 3 – A Long Butterfly with an “explosive” position in corn options
Figure 4 – Corn option position risk curves
There are a number of things to note about this position:
#1: The trade involves
-Buying 2 at-the-money July 690 calls
-Selling 3 July 730 calls
-Buying 2 July 750 calls
#2: The worst case scenario is that we hold this position until July option expiration and the options expire worthless, in which we would experience the maximum loss of $1,475
#3: Implied volatility is extremely low (around 23%) for corn options. We should watch for a spike in corn IV in the weeks and months ahead because…..
#4: The Vega for this position is $65.14. What this means is that for each point that implied volatility rises, this position will gain approximately $65.14. So if IV spikes from 23% to 33%, the value of this position can increase $650 base don volatility changes alone.
#5: We have a lot of time (126 calendar days) for something to happen
#6: Still, ultimately corn price must move higher at some point in order for this position to make a meaningful profit.
The purpose of this article is not to convince you to rush out and trade corn options – especially if you have never traded an option or a futures option before. Likewise, I am in no way attempting to refute the unfavorable outlook for corn presented cogently by Mr. Fletcher in Barron’s. No, the purpose of this article is simply to point out the potential to take advantage of situations using options that one cannot using futures contracts or shares of stock.
The fundamental outlook for corn appears to be legitimately weak, thus a long position in corn futures appears to be a questionable and potentially risky idea at best. Still, based on seasonal price and volatility history a trader might still wish to have some exposure to the long side of the corn market – without the unlimited risk associated with trading corn futures contracts. The position I highlighted – and there are many other possibilities, including taking no position at all – is just one example of a way to take advantage of "possibilities" via the use of options.
Is this stuff fun, or what?!
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site