Thursday, June 27, 2013
Hedge Strategies ahead of USDA Report 6-27-2013
Another hurry up and wait day for our markets as we await the USDA report out tomorrow.
When everything was said and done we had July corn up 3, Sept corn down 2, December corn down 6, KC wheat down 4, MPLS wheat was down 12 on the July, MPLS September was unchanged, CBOT wheat was off 3 cents, July soybeans were 14 higher, Nov beans down 1, US dollar about unchanged, gold down 29 bucks, crude up 1.25, and the DOW up 114 points.
Very wild day for the spreads today ahead of the report. At one time MPLS July was up 12-13 cents only to close down 12 ½. Most of the bids have long been moved to the September contract; but the price action today on spreads was probably just a small preview of what the spreads will do in terms of volatility as the USDA report comes out. It really seemed like a lot of bullish bets have been placed the past few days which opens up the door to a potential buy the rumor sell the fact.
Going into these type of potentially volatile reports a guy wants to make sure that they are comfortable in their marketing plan. For some that might mean doing nothing; but for others it might mean making a few catch up sales or getting some protection in place.
Here are some various strategies that one might use. Just remember that no strategy is right for everyone and for some doing nothing isn’t wrong either.
When you go into these reports you can look at thousands of different strategies; but remember if you are buying options right before a major report you are paying an inflated priced because usually implied volatility has risen heading into the reports. So sometimes you can buy an option right before a USDA report; get the direction right and maybe even have the market move as much as expected only to see that option value not move nearly as much as one might have hoped for. A lot of unknowns get answered in the reports and as soon as those unknowns are answered some of the premium (volatility premium) comes out in a hurry.
Bottom line before placing any of these trades make sure that you understand them and are comfortable with the risks and rewards with the various trades. Keep in mind that futures and options are risky and not for everyone.
The below are hedge trades for those that feel they want some sort of protection. Opposite type of trades could be made for bullish bets; but producers probably should be looking at hedging or protecting unsold inventory.
Hedge 1 – Simple purchase of a put. What strike and what month are the real question. First off what are you trying to protect? Old crop or new crop? Which one has the most risk? How much money do you want to spend and what is the potential reward? For me if I am going to buy a put to protect me from a train wreck from the USDA report I want to be an August serial month; which follows the September board. Now if I am looking to protect from lower prices via the weather continuing to be ideal that wouldn’t be the month I would use.
But for just protecting the report I like using August because I feel the most risk from the report is to the July contract followed by the September and then December contract.
Bottom line is I want to distinguish where my risk is at that I am trying to protect. In this case I am just looking at report protection; nothing more.
So I personally go with the August option.
So hedge 1 is simply buying a 5.50 August Corn put for 12 cents. Why do I choose a 5.50 strike instead of at the money 5.70 for 21 cents. Here is where I look at the what if’s. So if I want to protect a negative report; I want to protect a big negative report. So I compare spending 12 cents for a 5.50 or 21 for a 5.70 and say what happens to these if the market goes up; while that is easy they are both worthless in a hurry. If the market goes sideways then the 5.70 out performs the 5.50. But what happens if a week from now September corn is at 5.00 or 4.50. Not that I think that will happen; but you have to ask yourself if the old crop story somehow gets shut down via this report is weather going to help it find support???? Right now it doesn’t look like it.
So if we go to 5.00 on the September board would I be better if I owned 5.70 puts or 5.50; while the answer is 5.70’s unless you spent an equal amount of money on each of the strikes and in that case you would be much better owning more of the 5.50 versus. As example say you want to protect 100,000 bushels do you spend the 21 cents on 20 contracts or 21,000 buying the 5.70 strikes? Or for your $21,000 do you buy 35 contracts at $600 bucks a piece or 12 cents a bushel? If we go to 5.00 your 20 contracts of 5.70 would be worth $70,000; but your 35 contracts of 5.50 puts would be worth $87,500. If we go to 4.50 the 20 contracts of 5.70 puts would be worth $120,000 but the 35 contracts of 5.50 would be worth $175,000.
So there is hedge 1; buying a put; as mentioned for above reasons I like protecting where I think the most risk is from the report. Not where the most risk is from yields or production (which won’t be updated in this report). Thus I think I would choose the 5.50 August strikes.
Hedge 2 is buying the put and selling a call to pay for the put. Here is where things get interesting and more complicated as via selling a call you open up the door for margin calls. So you could look at selling a 6.00 August call; but personally I don’t think I would sell a call option against old crop corn. So I would look to sell probably a December corn call. What strike? There it depends on comfort and what your bias is for the report. The biggest home run and bank for your buck would be to sell an at the money corn call (5.40) and use that to buy say 3 to 1 of the 5.50 August puts.
Take the same example above; if we have 5.00 corn and you did this on 100,000 bushels; your put portion would be worth $150,000; and worth $300,000 at 4.50. But in exchange for this you might have margin calls and you have capped your upside on 100,000 bushels of December corn at 5.40. Plus even though the trade is a free trade it does cost money to put it on. You get paid for the calls that you sold but you have to margin them up and will continue to margin them up as the market rises. But you also have to pay for the 5.50 August puts that you buy.
Hedge 3 would be similar to hedge 2; but instead of selling the at the money corn call one sells the 6.50 Dec corn call and buys the 5.50 August put. Net cost being 1-2 cents; but here again net cost; not net cash out of pocket. This gives you some protection 1 to 1 ratio but doesn’t lock you into a corn HTA type of sale until we get to 6.50; know don’t get me wrong you would have margin calls well before Dec corn got to 6.50; but unless December corn is above 6.50 on November 22 you won’t have a short futures position at some point.
Hedge 4 adds another twist and that is buying a put and then selling one call and buying a higher strike call. For simple purposes we will say buy the August 5.50 put sell the December 6.00 call and buy the December 6.50 call. Net cost is about a penny or two. What this trade does is it caps the margin requirement and gives you as a producer re-ownership above 6.50. So you have 1-1 protection below 5.50 basis the September contract until 7-26 when the August put expires; as for the new crop if December corn is below 6.00 you have nothing; if it is between 6.00-6.50 you have something similar to an HTA at 6.00 and if we go over 6.50 you start gaining again. Not a bad move; a known cost.
Hedge 5 would be selling a call and use that money to buy a put spread. In this example sell maybe a December 6.00 call; buy a December 5.30 put and sell a December 4.70 put. Not sure that I like this trade; but many would prefer to buy and sell options in the same strike month and not have the calendar exposure. This would be more of a new crop play. Cost on this trade above is about 7 cents a bushel; it gives you a ceiling of 6.00 on your corn while giving you 60 cents protection; for a cost of 7 bucks. The bad thing about this trade is the fact that the 5.30-4.70 put spread won’t be at 100% value until December corn is well below 4.70 or until options expire. Via selling the put you have capped your protection and you won’t realize near as much profit as hoped for should we fall; at least not nearly as fast as one things because of how time value works.
Hedge 6 would be a calendar trade. As example some might look to buy an August 5.70 put and sell a September 5.30 put; net cost of about 8-9 cents. Easy to manage trade in many cases and the thing it does is it lets gamma work for you. The August 5.70 put will trade like a futures contract much sooner than a 5.30 September put. It is a good trade that if managed properly can easily win more than 50% of the time; the problem with it you just are never going to hit a home run.
Hedge 7 would be a different type of calendar trade; one that the stock market guru’s use a little more. Sell the 5.30 August put and buy the 5.30 September put; in this example you are just trying to get longer protection and the most the trade can cost you is what you spend on it. Or about 6 cents in this example. Hedge 6 has a short option that will be out there after your long option expires; this is the opposite. The difference is in this trade you are buying and selling the same strike; in the above you have a higher strike bought and a lower longer dated strike sold.
As you can see I think I could go on and on with various trades. I am not saying that anyone needs to have any trades on; after all they cost money and some of these ratio strategies cost plenty in commission. But you want to be comfortable in your marketing plan. Keep in mind that no one move is right for everyone; as all of you have different risks and goals.
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