Scheve: Why I Think Buying Calls Is Gambling And Why I Avoid It
Nov 05, 2018
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Market Commentary for 11/2/18
The President started tweeting Thursday about trying to work with China to end the trade war and the market rallied 30 cents. Friday morning a White House advisor said there wasn't much progress, but the market still closed the day positively. After the markets closed on Friday, the President said there had been a lot of progress made with China trade. This topic will certainly excite the market leading up to the President meeting China's leader at the end of November during the G-20 meeting.
Why I Think Buying Calls Is Gambling And Why I Avoid It
The Differences Between Buying And Selling Corn Calls
Buying Calls - Gives the buyer the right to buy grain at a certain price. There is a premium to be paid to own those calls, but there is no margin call risk.
Selling Calls – Can force the seller to sell grain at a certain price. Those selling calls collect a premium upfront for doing so. There can be margin call risk with selling a call option if the price rallies, but margin call is actually a good thing because it means prices went up. (Click to read why margin call is good)
Many farmers tend to buy calls. Analysts often discuss the "advantages" of doing this, suggesting it’s a great option for farmers because it allows them to sell their grain now and still take advantage of a futures rally.
Buying Calls Usually Doesn’t Work Out For My Operation
Buying corn calls shifts my marketing strategy into speculating (a nice word for gambling). Speculating or gambling adds risk to my farm operation, which is something I always want to be minimizing. Why is buying a call gambling to me?
Reason #1 - Buying Calls Has Terrible Odds
The chances of making money buying corn calls is about as likely as winning playing Keno, the game with the worst odds in a casino. When you buy calls you are buying TIME. The further out in time you buy a call, the more money it will cost you. Which means, the more you need the market to move higher. There are extremely smart people who have crunched the numbers using complex algorithms to determine exactly how much those calls are worth. So, I don't think it's wise to bet against these people and their computers. As time to expiration gets closer, the value of the call drops quickly.
Reason #2 - Buying Calls Doesn't Work Well With Market Carry
Market carry is when futures further in time are worth more than current futures. Corn is usually in a carry.
In a sideways market, like the last few years, it’s very difficult to be profitable buying calls, because the market doesn't increase much in value. Instead, far out contracts lose value as time progresses, eventually working back to the current value.
Reason #3 - Futures Value Changes Don't Correlate To Call Option Value Changes
Let's say that the market does increase between when someone buys a call and its expiration. The value of the option doesn't change at the same rate in the beginning of a rally. Usually the futures value change compared to the value of the option is 3:1. This means if someone buys a call and futures increase 30 cents, the value of the call will only increase about 10 cents. 3:1 odds isn't a very good return for my risk. Not only is it definite loss of the premium spent buying the call if the market is sideways or goes down, but, those buying a call would only benefit around 33% of actual move of a market rally that is less than 50 cents.
Many farmers have told me that they used to buy calls, but didn’t understand why they seldom made money over the long run. That might be because the only way to make money on calls is if the market moves a lot higher. But there are 2 guaranteed ways to lose money when buying calls...if the market goes nowhere or lower.
There Are 2 Exceptions Where I Would Consider Buying Calls
Largely I’m against buying calls for my farm operation. However, there are always exceptions to the rule.
- Protecting a sale BEFORE harvest from production issues if I’m over sold on my insured production levels.
- Inverse markets after harvest in which the nearby futures contract is higher than further out months in the same marketing year. This is not common in the corn market, but happens more frequently in the bean market.
The Difference Between Reownership And Buying Calls
I think all farmers should have 100% on-farm storage to best maximize their grain marketing profit potential, but not all farmers do. Instead, many will store grain at commercial facilities hoping for a price rally. Instead of holding the grain and paying storage fees at these facilities, it often makes more sense to just sell the grain at harvest, and reown the grain on paper. This avoids storage fees and allows farmers to wait for better prices.
Straight up reownership with futures or buying calls are two different strategies. To me its hedging vs speculating. The upside potential with reownership is much higher with futures than what options will provide as referenced with reason #3 above. Yes there is more downside risk with owning futures, but I think that risk can be protected with other hedge strategies like put options or seasonal trades.
As a producer I know I will always have more corn to sell in the future. In other words, I’m always long corn. If I buy calls, it gives me the right to buy corn at some point in the future. Since I know I will always have more corn, why would I ever want to buy more grain?
But If I Buy A Call I'm Not Going To Actually Buy Corn
That might be true, but the function of a long call option is to do exactly that.
2017 Buying Calls Example
Last November I heard an advisor suggest that farmers sell their grain in commercial storage when values were around $3.45 on the December and $3.75 on the July futures. This advisor suggested to reown their grain with the purchase of a July $3.90 call for 15 cents.
The market then rallied until late May hitting the season's high on the July contract at $4.12, which meant July futures increased 37 cents ($3.75 - $4.12 = 37 cents) since buying the call. However, the value of the call only increased to a value of 24 cents during the same time-frame. If the farmer sold the call they had purchased for 15 cents when the futures price hit $4.12, they would have received a 9 cent profit (24 cent value - 15 cents cost of the call = 9 cents profit).
So, in this example buying the call would resulted in 1 cent of profit for every 4 cents the market actually moved (9 cents vs 37 cents). And that's if the farmer knew to sell the call at the very top of the market. I suspect that most farmers wouldn't have been satisfied making only 9 cents of profit and would have held longer. The value of the calls were under the 15 cents paid for them 3 trading days after the market hit it's high. For anyone who didn't sell the call during those three days the trade would have been a loss. 3 trading days after the market high, the futures value was at $3.90 and it was another 10 days before the futures were trading below the values of the original trade at $3.75. Its certainly not a guarantee that having the futures position would have made money either, but the potential was greater than for the buyer of the call.
Losing On a Call Hurts Twice As Much As Doing Nothing
Had a farmer sold $3.75 July futures and then held the call until it was worth nothing, the farmer didn't get $3.75 for their corn, they really got $3.60 ($3.75 - .15 for the option). This trade ultimately could have added more misery to an already difficult year with prices below profitable levels.
Many people like to buy calls because they are easy to understand and they can make people feel like they have a chance to hit a home run. But in marketing grain, I find simple isn’t always best for my operation.
Buying calls has usually not been successful for my farm operation. Where I have had more success is SELLING those CALLS. Next week I'll explain some of that success, and why I'm always hoping I will lose money selling a call.
Like this article? Check out some others by Jon Scheve:
How I Collected 18 Cents On Some Of My Corn In A Sideways Market
The Difference Between Speculating vs Managing Risk
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Waconia, MN 55387
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