Change text size

• Email This Article
• Print This Article
• Digg This
• Delicious
• Subscribe

As the mainstream investment world begins 2009 with a haze of gloom over the markets, Option Sellers can start out the year taking a fresh look at the commodities markets and objectively decide which side of the market they wish to take (the bullish or bearish side) and how distant out of the money they wish to sell their premium. Let the mainstream media worry about bear markets and “value” levels. Option Sellers want to make their money now and they really don’t care which way the market is moving, as long as it stays away from their strike.

As we cover in The Complete Guide to Option Selling (McGraw-Hill 2005), the fundamentals of a particular market are the first and most important aspect of a trade that should be considered in any option sale. In commodities, that does not change, even in the extraordinary economic conditions we are currently experiencing. In fact, supply/ demand analysis becomes even more important as shifts in the balance of supply and/or demand are a clear reflection of what is happening in the overall global economy.

Funds may have pushed prices around a bit this summer. But as economic reality came crashing home over the past four months, commodities are once again focusing on their core fundamentals.

We at Liberty Trading continue to be of the opinion that the overall economic theme affecting commodities in the first half of 2009 will be one of opposing forces. A weakening dollar supporting commodities will be matched against falling global demand which will pressure prices. However, we expect the latter to be dominant in the first half of the year, with the former coming on in the second half.

There is nothing flashy here. We are not going to project big moves or look for the trade of the year. Nice, quiet, steady premium collection will suit us just fine and early 2009 could provide these types of conditions, at least in a handful of sectors. This brings us to the soybean market.

Soybeans are a versatile food and have enjoyed steady demand growth since China’s entry into the WTO in 2001. As developing economies began improving their diets, demand for soybeans grew – some from direct consumption, but more from increased demand for meat. Soybeans are a primary feed ingredient for cattle, hogs and poultry. As food is one of the last items people cut back on in economic downturns, soybean prices have not suffered to the extent that industrial items such as copper or oil have. Nonetheless, soy prices have fallen by nearly 50% since their highs in July.

Soybean’s fall was due not so much to a decline in demand (at least initially) as it was to speculator and fund liquidation. As fund longs had been mostly liquidated by late 2008, the market began to look to demand for price direction. As expected, global demand, even for foodstuffs such as soybeans, has declined which has kept a lid on rally attempts. Option sellers, however, are now looking for where prices will not go over the next 90 days. And that will be the subject of our analysis.

While some may argue that lower demand has been priced into the market, it should be noted that prices will need a reason to move higher in the first quarter of 2009. As the time of this writing, we do not see a clear reason why they should.

If animal feed is the key avenue of demand for soybeans (soybean meal), it is where a demand focused approach should begin. US Cattle on Feed inventories were down 6.8% in October and 6.2% in November as of the latest USDA report. This trend is expected to continue into 2009 as producers anticipate lower retail demand, especially for prime cuts.

Poultry feed demand is expected to drop as well. Weekly USDA Broiler Hatchery reports confirm that commercial hatcheries in the US set approximately 7.4% less eggs in the last 8 weeks of 2008 than in the same time period in 2007. With less livestock to feed, demand for soybean meal (and thus soybeans) declines.

There is a feeling in the industry that the USDA has not yet accounted for this expected drop in feed demand in it’s latest 08/09 ending stocks projections. Current USDA estimates for 08/09 US soybeans ending stocks (the amount of soybeans “left over” after all demand has been met at the end of the crop year on September 1) will total 205 million bushels. This is not gigantic by historical standards but is identical to 07/08 ending stocks. One must remember, however, that these are only estimates and there is a wide margin of error this early in the year. However, Liberty Trading Group is of the opinion that the USDA will make adjustments for declining demand in the early part of 2009 and that ending stocks projections will grow – possibly by as much as 20-30% of the current estimate.

Regardless, as South American production eclipses US production, we must look at global figures to get the true “big picture” in soybeans. Brazil is expected to produce about 60 million tonnes of soybeans this year – about 1 million tonnes less than last year. However, Argentina is picking up the slack, expected to produce close to 4 million tonnes more than last year. World ending stocks for 08/09, possibly the most significant figure for global soybean prices, are projected at 54.19 million tonnes. If realized, this would be second highest global ending stocks on record. Global stocks to usage ratio (ending stocks vs. total global consumption) is projected near 23% for 08/09, not a record but still near the high end historically. So much for the food shortage.

As this is a quiet time for Northern Hemisphere crops, the market will be primarily focused on the South American harvest and global demand over the next 90 days. The bulk of Brazil’s harvest will arrive in February and March and this new near term supply has historically tended to help quiet any existing market anxiety. While soybeans often begin pricing uncertainties over US plantings in March, we expect a later Brazilian harvest this year to delay the market’s US crop focus. In a year of declining demand, the prospects for a “Springtime” rally could be muted further. In addition, at current prices, US soybean farmers can still net close to $240 per acre of soybeans in 2009. Considering that prior to 2006, farmers regularly netted at or below $150 per acre, one can assume no shortage of soybean plantings this year.

When looked at as a whole, the fundamental for early 09 soybean prices can be summed up in one word: unspectacular. Prices may bounce around on fluctuations in the US dollar or fund entry or exits. But the theme of adequate supply and lackluster demand should weigh heavily enough on prices to keep a lid on any runaway rallies.

In summation, we do not expect soybean prices to collapse, especially if the dollar continues to decline. However, prospects for sustained rallies appear limited in the near to intermediate term.

While this may not sound too exciting for the average investor, this is exactly the type of market that option sellers seek to collect premium. With fundamentals projecting a bearish slant towards prices, we would look to sell far out of the money calls and collect the premiums. As a call seller, your options will expire worthless as long as your strike is not reached prior to expiration. Volatility is still high enough to sell call option premiums at strikes 40-50% out of the money for May or July contracts. We expect volatility to level off in soybeans in early 2009 and that could mean more rapid deterioration of the options.

We will be working closely with clients in positioning in this market over the next 7-14 days and will look to do so on limited rallies.

 

Figure 1: May 09 Soybeans

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/Optionsellers.com
Optionetics.com ~ Your Options Education Site
Questions for James and Michael? Visit the Optionetics.com Discussion Board

• Email This Article
• Print This Article
• Digg This
• Delicious
• Subscribe

Recent Articles by James Cordier & Michael Gross, Optionsellers.com

• October 1, 2009
  Commodities Roundup: Out of Gas
• September 17, 2009
  Commodities Roundup: Coffee
• August 31, 2009
  Commodities Roundup: Soybeans Crop
• August 19, 2009
  Commodities Roundup: Crude Oil
• August 3, 2009
  Commodities Roundup: Silver