Why I Prefer Selling Straddles Over Writing Accumulator Contracts
Nov 13, 2017
Market Commentary for 11/13/17
The USDA announced a record yield resulting in a 2.5 billion bushel carryout. Therefore, I think it's unlikely that corn will sustain a major rally until summer 2018. A soybean rally won't help corn prices either unless there is a devastating drought in South America. If there is a 2-4 million acre switch next year from corn acres to soybeans acres, combined with a weather scare, there may be a chance for $4.50 in the Dec '18 futures contract.
On the flipside, the slow harvest and the already huge fund short position is keeping prices above $3.40. It's uncertain if this can continue but it’s certainly positive that the market has still not traded below that point as of right now. Many end users missed their opportunity for $3.40 last week, it's unclear how long end users will remain patient or if they will chase the futures market back to $3.50.
Market Action – Selling A Straddle
I expect that for the next two months the market will bounce off the bottom following harvest and continue mostly sideways. Since prices are at unprofitable levels I want to try to "manufacture" some premium in the market while still maintaining low overall risk. Therefore, on 10/24/17 when March corn was $3.60, I made the following trade on 10% of my ’17 production
- Sold – January $3.60 straddle, where I sell both the $3.60 put and $3.60 call and collect a 15 cent premium
- Trade Expiration - 12/22/17
- Potential Benefit - If March futures close at $3.60 on 12/22/17, I keep all of the 15 cent premium
- Potential Concern - Reduced or no premium if the market moves significantly in either direction
- Every penny lower than $3.60 I get less premium until $3.45
- $3.45 or lower and I will be losing money on this trade penny for penny
- Every penny higher than $3.60 I get less premium until $3.75
- $3.75 or higher - I have to make a corn sale at $3.60 against March futures, but I still get to keep the 15 cents so it’s like selling $3.75
The biggest risk in this trade is if corn is below $3.45 at the end of Dec because I'll lose money. If this happens, I can buy the straddle back and take a loss, or remove a previous sale, and take any profits on the difference between what I sold on another trade and $3.45, against the March. Then I can wait for a future rally and sell again, adding that premium to another sale. While I hope this doesn't happen, and I think there is a low chance it will, I still ALWAYS understand the worst case scenario for all of my trades and am willing to accept them. It is also why I limited the amount of bushels I placed in this trade to 10% of my production.
What Is An Accumulator Contract?
More and more farmers are writing accumulator contracts. On the surface, these types of contracts seem appealing, but farmers need to understand exactly what they are agreeing to before jumping in to one.
With accumulator contracts, farmers can collect more for their grain than current CBOT prices as long as they double the number of bushels sold if prices exceed a specified price at some point in the future. There are many different types of accumulators, but most have "knock out triggers" which is when the CBOT price drops below a pre-determined price. Typically, these contracts sell bushels in small amounts daily or weekly until the end of the pricing period to allow for some bushels to be priced prior to any knock out trigger. Prices are usually based upon daily or weekly averages.
These contracts seem appealing because they can guarantee a sale price above breakeven points. Even with the 'risk" of doubling a sale, it means selling more grain at profitable levels. Also, farmers can usually write these contracts for less than 5,000 bushels, and probably most important to farmers, there are no margin calls.
Most people would think doubling a sale is the riskiest part of this trade. But actually the knock out price is the bigger concern. If the knock out price occurs, the farmer only prices some of their grain. It depends when the knockout was triggered and how much time remains until the pricing period ends. That could mean a farmer risked pricing 2 bushels to the upside, but if prices go down and hits the knockout trigger, they could only end up selling maybe half of their bushels. In other words, if prices stay low, farmers receive the worst possible scenario of low prices and less grain sold than originally planned. Farmers basically have no control over when or if that will happen.
Also, whoever underwrites the accumulator will usually take additional hidden fees out of the contract. These fees are hard to identify because usually the underwriter just doesn't pass along all of the profits of the underlying options trades that cover the contract. This could account for about 5-10 cents of potential profit, which is used to cover the costs of margin calls that the underwriters will cover instead of the farmer when putting this contract on. There are also typically 5-10 cent commission fees for the salesperson and company putting the trade together with the farmer. All of those fees are a lot of money when prices are so low and it can be the difference between a farmer selling at profitable prices or not.
An Alternative Solution – Selling A Straddle
Often farmers don’t realize they have alternative solutions. This is due to a variety of reasons, but when farmers know all of their available options they can make the best decision possible for their farm operation. Following is one of several different ways that a farmer can do things that are like an accumulator contract, but with potentially more flexibility and fewer fees.
Rather than Accumulator Contracts, I prefer Selling Straddles (like the trade example above). Usually I sell a futures contract at some point before I sell a straddle. (A farmer in theory could even sell to an end user first with a cash or HTA contract). How it works - I sell a straddle for a future date where I think the price WILL be (not what I HOPE it will be). Then I collect the premium from both the selling of a put and the selling of a call. On the expiration date, the further the futures price is from the predicted (strike) price I picked, the less premium I keep.
The Difference Between An Accumulator Contract and Selling A Straddle
In the straddle example above, I think at the end of December that March corn will be around $3.60 and I will get 15 cents if it is. If it is between $3.45 - $3.75, I keep additional premium one cent less as the price is further from $3.60. Under $3.45 I lose money or have to buy back another sale I had previously made. While over $3.75 I lose money or I can make the additional sale.
If this had been written as an accumulator contract there would likely be a knock out clause if March corn hits $3.45 ANYTIME before the contracts ends. With a straddle, the market can fall below $3.45 before the expiration but as long as it is over $3.45 ON the actual expiration date I still have potential at profits. So, the straddle has more flexibility. I only have to worry about prices hitting $3.45 on ONE date, rather than a RANGE of dates. Plus, the commission on a straddle is at most 2 cents, when accumulator contract commissions are usually 5-10 cents.
But, When Selling Options You Can Have Margin Calls
Yes, however too often farmers let the fear of margin keep them from doing trades that can really benefit them. While margin call isn’t always ideal, it’s important to keep the threat of it in perspective. In this example, I would need futures to move over $1/bushel and maintain that move for a year, and even then I would only incur a 5 cent/bushel interest charge on the margin call money.
Are Accumulator Contracts Bad?
No, accumulators aren’t necessarily bad. They can be a useful tool under the right market conditions. However, farmers need to understand exactly what they are getting with these types of contracts (i.e. all the pros AND cons). Often trades can look good on paper, but there are hidden fees and costs not easily seen at first. Sometimes alternative options, like selling straddles in this case, can provide more flexibility, more control, fewer fees, and potentially more premium. When prices are consistently below profitable price points, farmers need to do everything they can to squeeze every penny out of the market they can.
Superior Feed Ingredients, LLC
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