Thursday, December 23, 2010

How to play the corn inverse?

I had someone ask me the other day what type of option move has the best chance to work with the corn inverse from July to Dec futures.

I thought about it and here is my line of thinking.

An inverted market is a market that shows a lack of supply or strong up front demand.  A carry market shows a lack of nearby need.

So under that thinking; I asked my self what type of move works if the inverse gets bigger but also has little risk if we see the inverse go to a carry.

Selling a put would be move that works if we go up on the July futures, as would buying a call provided we go up more then what one spends on the call.......but that it self doesn't really play the spread or play the market based on what the spread is; plus if one is a producer to simply add on more bushels and have to pay for the right to own them doens't make ton's of sense to me.

Now i turn my thoughts to what move works if we go sideways, see the inverse get bigger, or see it go to a carry.  If we go sideways and I sell a put it can be at the money or under the money to still work; if it is a call that i sold it can work in 2/3 ways........and if I own the option and we go sideways it simply has a slim chance of working.

If the inverse gets wider what probably happens to the July futures; they probably go up.  So in that line of thinking selling a put if the market stays inverted or inverts more then it all ready is likely to work and highly likely to work if that put is under the market.

So I then looked at the sale of a 5.50 July put for about 40 cents.......and I said what other leg or legs help the trade be more profitable based on the fact that the market is an inverse; without super exposure.  Keep in mind that in futures and options there is always risk and many times the risk is much more then it seems.

If one takes the money from selling the 5.50 July to to buy a Dec call spread how does that line up to market expectations that go with a inverted market and what happens if it goes to a carry.

It doesn't work the best if one buys something at or above the money if we see markets simply fall apart; not to say that it couldn't turn out great; but the odds don't seem to be great if we go up, down, or sideways.

But what If one buys a Dec 5.00 call and sell's the Dec 6.00 call; paying for that spread with the sale of a July 5.50 put.

If the market rallies the long call works; short call caps what the long call can make; but the short put works.  If we break could it be a lack of nearby demand?  If so what happens to the Dec board that is right now about 70 cents off of the July board?  It should show some strength releative to the July.

So now I have my thoughts on what trade is most likely to succedd given the inverted market and fundamentals as well as price direction that it is trying to tell us.

I then used RJO's Position Book software to run some different What if's

I looked at simply if nothing changes and one holds all leg's to experation what is the trade worth?  Presently with July corn about 6.20 and Dec corn about 5.50; it makes 50 cents a bushel or $2500 per trade.

What about if nothing changes and it is now late June right before the July options expire?  Based on no changes we should see the trade worth about $1900-2000 or 35-40 cents a bushel

What about a rally of 70 cents on both?  Based on exciting around June 24th; I figure it is about $4000 or 80 cents a bushel and if held it would give us our max of a dollar a bushel or about $5000 per trade

Here is screenshot of mentioned trade using the Position Book software.

I would point out that as a producer I question wether this type of strategy is a hedge or a speculative move.  I guess one could say that it could be considered some sort of hedge versus previous sales that went bad or now seem to cheap and the trade is very simliar to a stock replacement strategy.  In that one is willing to re-own on a hard break.  Right now who wouldn't want to own 5.50 July corn when it is worth $6.20?  The calendar or time portion also adds more risk; as it is possible for the market to break hard enough that the long Dec call ownership doesn't offset the losses in the July corn on a break.

In trading most have a pre-defined risk/reward;  I would reccomend that producers also have some sort of risk/reward that is predefined.

The other big thing that inverted markets tell me as a grain merchansider is not to carry product that is worth less a couple months from now comparted to value today.  I.E. carry markets pay producers and elevators to store the grain; while inverted markets charge one to hold/carry the grain unless something changes.  Because of this I have always been taught not to hold any length into inverses.

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