Understanding How To Capture Market Carry
Dec 18, 2017
Market Commentary for 12/15/17
This week the USDA report and the markets were uneventful. Farmers aren’t selling and corn export demand is pacing slow. Good weather conditions in South America eroded bean market premium.
Understanding How To Capture Market Carry
I recently attended a grain marketing conference where the presenter discussed ideas for farmers to be more profitable in the current marketing environment. One suggestion mentioned was to sell the market carry (i.e. when the further future month is higher than the current future month). This is a popular recommendation trending right now, but it’s been something I’ve been advocating for years. It’s a relatively low risk opportunity for farmers to pick up additional premium and add profits to their bottom line. I think all farmers should be doing this.
However, this strategy is often casually mentioned as something farmers should be doing with minimal detail and explanation. But in my experience, many farmers don’t really understand how to capture market carry effectively and the upfront planning and logistics required. In short, market carry can generally only be captured if the underlying crop is sold and usually is physically store in a bin on the farm.
How Does This Work?
Step 1 – Farmers need to first pick a price and sell their grain using futures
Step 2 – Farmers need to decide WHEN they will want to physically move their grain. This determines the month they will capture the carry from.
Step 3 – Farmers need to choose WHERE they will move their stored grain (i.e. the actual location). This will allow them to set their basis.
Farmers can use HTA (Hedge To Arrive) contracts, which would cover some of these steps. However. I prefer to keep my options and choices open until the very end on where I’m physically selling my grain. This allows me to not only take advantage of market carry, but also upside opportunities in the basis market too.
Let’s say a farmer wisely sold corn when Dec ’17 futures were $4.15. This farmer could then “roll” that sale from Dec ’17 futures to July ’18 futures and capture 30 cents of market carry (avg 5 cents/month), ending with $4.45 against July futures and physically selling his grain for delivery in either June or July.
What If Farmers Aren’t 100% Sold For Their 2017 Production?
That’s the thing, I haven’t met any farmer with more than 50% sold for that $4.15. Most farmers are at best 20% sold for around $4. The rest is stored unpriced. So, it’s easy to recommend to farmers to add 30 cents to that $4 priced grain, resulting in $4.30 for summer delivery.
But, What About The Other 80% That Is Unpriced?
Exactly. It’s very difficult to capture market carry effectively on that. The presenter in the meeting suggested that farmers sell July futures for $3.70, which was 30 cents higher than Dec futures that day. But, there aren’t many farmers who want a $3.70 sale against July futures because that’s below many farmer breakeven points.
The presenter then suggested farmers should reown that sale by purchasing a July $3.90 call for 15 cents to allow for upside potential.
The Problem With Buying Those Calls…
As always there are three possible directions the market will go (up, down, sideways). So what are the possible outcomes of this trade:
· Corn remains sideways or goes lower – The farmer is out the 15 cents to buy the call. So, instead of $3.70, the farmer is sold at $3.55 against July futures ($3.70 futures sale – 15 cents call purchase price). Interestingly, $3.55 was the same price as March futures that day.
· Corn rallies 20 cents by May – This was what the presenter expected as the likely scenario. The call would then conceivably be worth 22 cents (a 7 cent net gain), meaning the sale would be $3.77 against July, which is still not above most farmer breakeven points, and this is maybe the best case scenario of this trade.
To me this is a Lose-Lose marketing strategy. Why would farmers want to risk 15 cents to make only 7 cents?
But What If Prices Rally More Than 20 Cents?
Technically the upside is unlimited when buying calls and prices could rally more than 20 cents, but how likely is that? Even during the presentation, the speaker painted a very negative market outlook long-term, prior to recommending that farmers buy calls. If he really thought prices were unlikely to rally, then buying a call doesn’t seem prudent. In fact….if a farmer thought the market was likely to rally higher than 20 cents, it would actually be more profitable to wait and do nothing, than trying to capture the carry and spend any money buying a call.
So, What Are You Doing?
My preference recently has been to SELL call options and collect the premium in the short-term, waiting for the market to rally. I still need to price 85% of my ’17 crop, so I can’t afford to lose money on any options if the market stays sideways or worse goes lower. Instead, I’m collecting part of the carry now, by selling the call premium, and I still have the potential to collect more premium down the road. Obviously I don’t have downside protection doing this, but I don’t think I’ll need downside protection on my corn in spring and early summer. Historically, the seasonal trend is for prices to stay steady or rally during these times. Of course past performance is not indicative of future gains so I do have risk, but I think it's minimal.
I’m hesitant to wait until next summer to collect all of my carry. Therefore, I prefer to spread my risk across multiple trades and months. By doing this I may be able to collect some market carry earlier. Following are two recent trades illustrating this.
2 - New Trades - Selling Calls
On 12/1/17 when March corn was near $3.59 and on 12/4/17 when March corn traded to $3.55, I sold the following calls:
- Feb $3.55 call for 10 cents – expires Jan 26th on 10% of my ’17 production
- Mar $3.60 call for 10 cents – expires Feb 23rd on 20% of my ’17 production
What Does This Mean?
- If corn is trading below the strike price (the price listed on each line) when these options expire - I keep the 10 cent premium and add it to another trade later.
- If corn is trading above the strike price (the price listed on each line) when these options expire - I have to sell corn for the strike price PLUS I keep the premium, which means, I will have an average price of $3.683 between the 2 trades ($3.583 10 cents option premium). If this happens, I’ll then roll these March futures sales to July futures to pick up an additional 16 cents market carry. Ending with – Approximately $3.843 Total
But What If Prices Rally? You’ll Have Missed Out!
Obviously, I don’t really want to sell any corn for $3.583 Mar futures. BUT if this happens, it means prices rallied, which is a great thing, because I can then sell more of my other unpriced corn at higher levels. And it’s not just 2017 productions’ unpriced grain that will increase, but 2018’s production too.
When developing my marketing strategy, I’m not worried about missing out on unforeseeable rallies. I’m much more concerned if prices DON’T rally and I have to sell substantial amounts of my corn at unprofitable levels. That’s why I’m “manufacturing” prices right now that get me to profitable levels.
Superior Feed Ingredients, LLC
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