Using Calendar Put Spreads for Low Prices
Nov 15, 2013
It is our understanding that much of the 2013 corn production may be unpriced. Yields were better than anticipated and many were hoping for corn to be back above $5 at this time.
Hope for higher prices and fear that the highs may already be in has many producers doing nothing but waiting. At this point we have to assume that the 2013 corn production will continue to increase before we see the final numbers in January.
The worse-case scenario could be the producer continues to store hoping for a bounce next spring on the premise that seasonally there is a potential fight for corn acres. While we may see a minor bounce, it may be difficult for December 2014 corn to move much above $5. The reason being the large amounts of unpriced inventory in farmer’s hands along with weak prospects of demand due to the uncertainty about feed usage, ethanol usage and the overall level of exports in a global contracting environment.
We believe that producers still have limited protection in place for expected 2014 production. While we don’t want to deter producers from holding off for higher prices in regards to cash sales into the spring/summer time period, we would suggest in these economic times it would be prudent to have a solid downside risk program in place just in case a weather price event does not occur.
Be prepared to sell futures or cash in the spring/summer time period if a price event does occur, but focus on getting a calendar put spread in place. Essentially, focus on selling the May puts now with harvest ending. Once the puts have been sold, focus on buying the Sep or Dec puts. One is essentially assuming some type of seasonal price stability in this strategy.
A rally is not necessary to make this strategy successful; the market simply needs to stop going sharply lower. Essentially, the focus of this strategy is to take advantage of a sideways to higher market to capture the time value decay of the short put in order to pay for the Sep or Dec puts.
Sell 1 May $4.20 out-of-the money puts for 13 cents with a net delta exposure of .3072 or for every 10-cent move in futures, the premium should change .03072 cents.
Buy 1 Sep $4.30 out-of-the-money puts for $.231. This would result in a net long put with a net delta exposure of .3347
To figure the net risk on a daily basis, take the net short delta [.3072] and subtract the net long delta of .3347, which results in a net .0275. This figure, however, is not a static number and will increase or decrease with the move in the market. However, for planning purposes let’s assume for every 10-cent move in the underlying futures one should expect a little over a 1 cent move positive or negative in the position. It should be noted that other factors, such as changes in volatility expectation, can change premium as well, but for now we will assume this value as a constant.
Receive 13 – 1 commission or .12 received
Spend 231 + 1 commission or .241 cost.
The plan is if the May puts expire worthless in mid-April, the net cost of the Sep $4.30 put has been reduced to 12 cents. By starting with the May puts, there is the potential to sell July puts at expiration in order to reduce costs even more. Another alternative is to use the money received from selling a July put to roll the long September put to December. There are several ways to adjust this strategy to increase or reduce the risk.
In regards to selling puts, the lower the strike price sold, the greater the odds it will expire worthless but less income will be received to pay for the long put. If selling a lower strike price is elected and multiple positions are sold, one must understand there is a greater responsibility of managing the risk of the short July puts if the market does move sharply lower.
In regards to buying puts, if one desires to spend less money, focus on buying Sep puts. The only problem is the market has to break faster and the August Supply/Demand report must be very bearish.
HOW MUCH RISK TO ACCEPT:
The risk of this strategy is the assumption the market is not going to crash between now and when the short put expires. If it does, we see two ways to manage risk:
- Stop orders cannot be placed on option positions so one would have to watch closely and, if the market is trending higher, risk no more than 10 cents or the money received for writing the short put.
- Roll the short put down: We suggest never allowing the put to go more than 10 cents in-the-money. Another way of thinking is we don’t want our short put to ever have a net delta of more than .45.
The end objective is to have a very low cost Sep or Dec put position in place below the market in case a price event does not occur to get to price levels where one wants to sell inventory.
If anyone has questions and would like to discuss marketing strategies, call Bob or Laura (1-800-832-1488). We will also try to answer questions in upcoming blogs and we welcome emails to email@example.com or firstname.lastname@example.org.
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