Commodities Roundup: Fed Bailout, Short Selling, and the Silver Lining for Commodity Option Sellers
September 29, 2008
You may notice that in our print articles, we at Liberty Trading take pride in indentifying key fundamentals of commodity markets in order to determine price direction (or for our purposes, non-direction). As you may also have noticed on TV, newspaper or Internet, fundamentals are out the window this week. Unless you have been living underground for the past 10 days, you have no doubt been witnessing, to one degree or another, the most historic shake-up in the US financial system since the 1930s. The speed at which the credit crisis climaxed caught even the most astute investors off guard. As Nick Carraway once described bankruptcy in The Great Gatsby, it happened “gradually and then suddenly.”
Therefore, in lieu of analyzing the supply/demand fundamentals of a particular market this week, it may be a more valuable exercise to look for opportunity by first stepping back and looking at the macro-economic picture as a whole – and how it could affect commodities prices.
In our last article dated September 12, we suggested that the US dollar could be supported into the fourth quarter as European and Asian economies followed the US into an economic slowdown. That view obviously may have to be altered in light of the current events now shaping the financial world.
The uncertainty present in the market now is the one constant. It seems a given that the US Congress will bail out the financial system to one degree or another. The questions loom, however, as to what degree of aid will be offered, the speed at which the government will grant approval and how it will be implemented. The larger questions remaining however are 1: Will it work? And 2: How will it affect the markets?
How it will affect equities remains to be seen and that is a question we would not care to address at this time. Fortunately, we trade commodities – hard, physical products that people need to eat, drive, drink and build. Unlike some shares of stock or debt paper, these materials will always have a value.
We have received some questions this week as to how the new rules affecting short sales will affect commodities option sellers. The answer is that they don’t. The rules were put in place to limit short sales in certain financial stocks. They have nothing to do with commodities or commodity options. In fact, other than some uncommon volatility in certain markets, it has been business as usual in the commodities pits.
To that end, one constant that has been present over all of the past 2 weeks has been volatility. While many have cited surges in the VIX index, volatility in commodities like gold and silver hit 20-year highs this week.
For option sellers, volatility is the silver lining to market turmoil. Volatility makes option premium available at strikes that would be unheard of under normal market conditions. That means that if you have a fairly good idea of where prices are not going to go in the next 60-90 days, you can often sell yourself some high probability option premium with little fear of the strikes ever going in the money.
For potential profit opportunities, a quick analysis of the underlying fundamentals can help identify the most promising candidates. If and when markets do settle down, traders will eventually begin trading on fundamental values more closely.
Commodities have taken cues for movement this week primarily off of moves in the US dollar which is directly linked to what our friends are deciding this week (or next) on Capitol Hill. How these decisions will affect the dollar in the short term remains to be seen. However, it is likely that some sort of bail out will take place. Assuming it does, it is hard for us to imagine how the US government spending $700 billion to acquire “toxic” debt could be construed as bullish for the US dollar.
Several big names in the industry that are smarter than I have suggested that the US taxpayer could eventually show a profit from the purchase of these distressed securities. And this may very well be the case. However, the key word is eventually. In the short term, the US may be seen in a slightly more precarious financial light by international creditors. This could translate into a resumed weakening of the greenback.
A weaker dollar would support commodities and some are suggesting a resumption of the bull market that was so prevalent in the early part of 2008.
A good point, but we feel an even larger counterweight will be slowing global demand. Granted, this could be considered a fundamental. But it is a big picture, all encompassing fundamental. Regardless of a Federal bailout of the of US financial system, I know of no one predicting a miraculous surge in the US or global economy in the coming 3-6 months. Quite the contrary, it now appears that the US, Europe, Russia and even China are experiencing a slowdown to some degree or another, regardless of what transpires in Washington over the next week.
We see these two macroeconomic forces as the big picture drivers of price in the coming quarter and probably beyond. In weighing these two factors, we can now look at some near term fundamentals of markets in search of trading opportunities likely to benefit from the current volatility. A good example of this is the call premium now available in Unleaded Gasoline.
If one is looking for an example of how high commodity prices and slowing economies have cut demand for physical products, one need look no further than the energy markets. Yet, US gasoline inventories are currently near record low levels, largely as a result of Hurricane Ike taking some Gulf refining capacity temporarily off line. This is one reason why retail gasoline prices have not yet fallen to the extent that crude prices have. This has kept retail gas prices artificially high and continued to erode US demand. The latest EIA report shows gasoline demand in the US down 7.6% last week compared with this same period last year. That is a substantial drop. Over the past month, US oil demand is down 5.3% over last year – largely as a result of drops in consumer demand for gasoline.
And the trend is not limited to the US. Japanese oil imports (Japan imports most of its oil) were down 3.3% in August over the same period last year. In fact, oil and gasoline demand has shown year on year declines in most all European and Asian consuming nations over the last several months.
A Federal bailout may save the financial system. However, it is unlikely that it will be able to stave off (although it may lessen the severity of) an economic slowdown, if not an outright recession. This means, less people driving to work, less trucks on the road delivering products, and less business travelers – not to mention general “belt tightening” by the US consumer and the gradual but steady shift to higher mileage and hybrid vehicles. Furthermore, unleaded gasoline does not enjoy the seasonal demand benefits that can often support heating oil and/or natural gas prices this time of year. This means that in the unlikely event of a sustained energy rally, gasoline would almost surely be the “weak sister.”
This makes it a solid candidate for a call sale.
The good news for traders is that the volatility of the past several weeks remains in the market, even with what has been nothing but a steady (and well entrenched) downtrend in Gasoline (RBOB) prices since mid-July. There is still call premium available at strikes near the $4.20 level for winter gasoline contracts. This is almost 40% out of the money and a full $.60 per gallon above July’s bull market highs. This means that as long as January RBOB Gasoline prices remain below $4.20, the call seller will keep all premium as profit. Premiums at our desired strikes are currently running in the $400-$600 per option range.
In summary, bail out or not, global economies are and will probably continue to slow in the coming quarter. And one of the first casualties of such slowing will almost surely be energy (ie: gasoline) demand. As US gasoline demand continues to decline and Gulf production facilities come back online, expect inventories to build through the fall, and prices to weaken into year’s end.
The economic turmoil of the past two weeks has been stressful on us all. Now it’s time to look for the silver lining the resulting volatility has created and put some premium in your portfolio. Betting against a big rally in unleaded gas looks like a good place to start.
Figure 1: January 09 RBOB (Refined Blend Gasoline)
Note: The opinions presented here are that of Liberty Trading and not necessarily shared by Optionetics and/or its instructors.
James Cordier & Michael Gross
Contributing Writers, Liberty Trading Group
Optionetics.com ~ Your Options Education Site
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