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Market Commentary for 12/17/18
While last week's bean trade with China was one of the largest single day trades ever, it was still significantly less than the market was hoping. The market will need at least 3 more trades like this to get excited. Plus, time is running out for US exports before the South American harvest starts.
There were rumors China could make its first major corn purchase from the US in 5 years. This could keep corn prices from dropping even if beans would continue to slide lower. The current rumored purchase size won't likely be enough to spike prices much higher.
The Pros And Cons Of Selling Straddles
Recently I heard a farmer ask an analyst what they thought about selling straddles. The analyst said he didn't recommend them and referred to them as "extreme trades." I'm guessing he meant they should be avoided because they were full of risk.
With the prolonged sideways corn market at unprofitable prices, all grain marketing solutions need to be considered for me to stay profitable. No trade is off the table as long as I fully understand and accept all possible market outcomes (i.e. up, down and sideways) when I place each trade.
For the past 2 years I've had a lot of successes selling straddles.
But like all option trades, they aren't perfect, and one needs to fully understand the pros and cons of using them.
What Is A Straddle?
A straddle is when I sell a put and a call at the same price (i.e. the strike price) and collect a premium to do so.
Selling A Call - I give the right to someone to buy grain from me at a certain price. This is a hedge for grain producers.
Selling A Put - I give the right to someone else to force me to buy their grain. By itself, selling pus is not a hedge for grain producers because it adds risk to my operation, because it means I may have to buy grain at higher levels than where the market is at when the options expire.
Recent Straddle Example
Straddles can be complicated to explain, so I think showing a recent trade example illustrates how they work best. Here is a straddle that I put on and expires this Friday:
On 10/2/18 when March corn was around $3.77, I sold a January $3.75 straddle and collected just over 23 cents total on 10% of my 2018 production.
What Does This Mean?
- If March corn is $3.75 on 12/21/18, I keep all of the 23 cents
- Every penny corn is below $3.75 I get less premium penny for penny until $3.52.
- Every penny higher than $3.75 I get less premium penny for penny until $3.98
- $3.98 or higher - I have to make a corn sale at $3.75 against March futures, but I still get to keep the 23 cents, so it’s like selling $3.98
- $3.52 or lower – I have to take a loss on this trade penny for penny below $3.52.
My Trade Thoughts And Rationale When I Placed the Trade:
This trade is most profitable in a sideways market, which I thought was the most likely scenario at the time of the trade. If the market goes nowhere and is still at $3.75 on 12/21/18, I'll profit the most by keeping all of the 23 cents. If the market stays range bound between $3.52 - $3.98 I'll still profit something between 1 and 23 cents. If the market rallies above $3.98, I'll be happy because it will force me to sell corn for a value equal to $3.98 (3.75 .23 of premium).
Another reason I made this trade was historically prices don't usually decrease from mid-October to mid-December. However I still need to be monitoring the market and may need to make adjustments to this trade if the market drops significantly to minimize losses.
What Is Your Goal Selling Straddles?
The goal is to generate some premium during a sideways market at unprofitable levels that I can later add to other trades that help me finally sell my corn at profitable levels. As this example above shows, I'll get the most premium if the market does nothing. The more the market moves, the less premium I get.
A big rally will force me to sell, but there is a good chance I'll get more with the added premium of the trade than the actual rally, unless the rally is really high. If a really big rally should occur, I'll be thrilled to sell my remaining unpriced grain at the much higher levels. Every time I place a trade, I know the price I will be forced to sell at and I'm willing to accept that price.
Today March corn is $3.84. If the price doesn't move before Friday, the day the options expire, I will reverse out of the trade above and collect 14 cents of premium I can add to a later trade ($3.75 puts and calls - $3.84 current price = - 9 cents 23 cents sold straddle premium = 14 cents).
What If The Price Of Corn Goes Down?
This is why a straddle isn’t a perfect hedge, it doesn't provide a floor price for unsold grain. This trade is built for the market going nowhere or higher. I still make a premium at the lower end of the range, but below $3.52 I don't have the grain protected and I could lose money on the trade.
That Sounds Like Added Risk?
Selling a put, which is part of a straddle trade, does add risk to a grain producers position. But, I can mitigate that risk by purchasing lower value puts that reduces my chances of losing money on the trade. For example, I could have bought a $3.55 put for 2 cents when I originally placed this straddle on.
However, before placing any trade I always balance how much money I'm comfortable losing with how much profit I'm willing to miss out on. In the trade above there wasn't risk protection to the bottom side. However, I felt comfortable making the trade because historically futures don't usually continue downward from October to December. It's usually been sideways or higher. Still, this isn't a "set it and forget” trade. I'm keeping an eye on the market in case it goes down, and if it does I can quickly make some adjustments to minimize losses.
Is There Margin Call Selling Straddles?
If a farmer sold a straddle, but didn’t buy the lower value put with the trade, they would have margin call exposure if the market moved in either direction. However, when farmers buy a lower value put, there is only margin call if the market rallies. Farmers are often fearful of margin call, but I'm not because margin calls mean the market has rallied, which I always want to happen. Margin call is a good thing because I always have more grain to sell in the future at higher levels.
If I didn’t buy the lower value put then I would have to worry about margin call if the market goes lower because the trade can lose me money and I don’t have my production protected to the downside. Margin call from the market dropping in value is not a good thing for a grain producer and it means that a speculative position is in place.
This Type Of Trade Seems Complicated, Why Do It?
The process is admittedly a little complicated, but in my experience simple grain marketing solutions are rarely the most profitable. And while the technical aspects of setting up the trade are complex, the strategy is relatively simple. Straddles are profitable if you can guess where prices will be at a certain point in time. The closer you are to guessing the correct price, the more premium you get.
How Much of Your Grain Do You Sell Using Straddles?
While I think there is a lot of rationale why the market will continue to trade sideways for quite a while, I still limit using straddles to no more than 33% of my production for each crop year. I use that percentage because there are 3 directions the market can go - up, down or sideways.
While there are benefits to selling straddles, they are NOT a perfect solution. They do NOT provide downside protection and they can limit upside potential. Still, they can be an effective tool in generating premium in a range-bound market and still allow for getting better prices if a rally happens.
Want to read more by Jon Scheve? Check out these recent articles:
Superior Feed Ingredients, LLC
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