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To understand commodity futures prices, you need to
understand the production and consumption of the commodity in
question. Some
futures contracts are based on annually produced commodities:
Corn, Wheat, Soybeans, Cotton, Cattle, Hogs, etc. These annually
produced commodities tend to have supply available at a single
time (harvest), while demand is variable and occurs throughout
the year.
Anticipated
changes in supply and demand can create unstable conditions,
markets can move farther than would normally be thought likely
- and can stay at these levels longer than most people would
anticipate.
Understanding the transition periods between certainty
and uncertainty is the key to understanding futures
prices. Let’s
focus on those periods of potential change to future supply or
demand that tend to reoccur on a consistent basis. By placing these
reoccurring events into the context of supply, demand, and the
current market you can narrow down potential trades to those
where profit potential exists.
The seasonal patterns of the grain markets are some of
the most consistent patterns in the commodities markets, and
there are fundamental reasons that these markets react in a
similar direction during certain periods of the year. These seasonal
patterns can also be seen as well in the volatility of the
futures contracts.
The difference is that expecting a seasonal change in
volatility is much more reliable than a change in price. This can easily be
seen by looking at a historical chart of volatility. Using the grain
markets, let’s look at an example using corn. Here is the historical
Volatility Chart for corn with a price chart superimposed on
it:
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The solid red line represents the actual volatility of
the corn contracts, the blue dashed line represents the
volatility implied by option prices, and a simple bar price
chart is shown in the background.
The marketing of last year’s crop and transportation
are the two dominant features of the grain markets in
February. Most
farmers sell their grains to elevators, which store and market
them throughout the year. Most elevators are
located near grain producers in the
Midwest and it is difficult to market
their stores until spring (since most inland waterways like
the Saint Lawrence Seaway are iced over
during winter).
This tends to create a supply surplus in the
Midwest and a scarcity on both coasts,
where much of the US population lives.
Also, most grain producers operate on a calendar year
tax basis, so they tend to step up marketing at the start of a
new tax year.
They also need to begin raising money to finance
planting, as well as make their tax and land lease
payments. These
factors tend to suppress grain prices in the beginning of the
new year, and drives grain prices lower during February.
With the current weak export picture, the corn market does not
look too promising in the short term, and typically following
a weak January, corn prices tend to make a lower low in
February.
Following the last 10 weak Januarys (out of the
previous 20 years), corn futures have posted a lower low in
February 9 times.
Though February is usually bearish, time works against
bears in the grain markets. With planting around
the corner and the inland waterways thawing, grain markets
typically turn in March when the important fundamentals shift
from marketing of crops to planting and the uncertainty
regarding future supply.
Grains tend to exhibit the most strength at the
beginning of their production cycle, and the futures are most
likely to rise during the period between field preparation and
the completion of planting. This is because if
planting goes poorly - too much rain, too little rain, too
hot, too cold - the yield will be lower and supply less. Since no one can tell
the future, the market builds in a risk premium to compensate
producers for the risk involved. These upward moves in
the grain markets are best viewed as opportunities to sell
into strength, rather than the start of a bullish trend.
For traders, the best time
to enter a position is when a market has a strong historical
tendency for a directional move. Going long corn
futures would be the obvious way to take advantage of the
anticipated price increase. However, while corn
prices often increase at this time of year, it is not always
the case. While
January 2001 saw the worst performance in January for
the March contract in the last two decades, it was not
followed by a strong rally in March. Instead (after a
smaller than normal rally) corn futures prices then continued
to plunge all the way until June.
This unusual price behavior creates a situation that
favors an options trader. Options allow you to
build a risk profile that takes advantage of both price and
volatility changes while tailoring risk to your comfort
level. An
aggressive strategy would be to simply buy call options. This strategy limits
your risk better than simply being long the underlying. Call options increase
in value when the price increases. They will also gain
value from increases in implied volatility. Even when prices drop,
some of the loss in a call options’ value is offset if
volatility increases.
A more conservative strategy would be a non-directional
trade like a long straddle or strangle, where you don’t care
which way the price moves. The long options on
each side gain in value from increased volatility, and large
movements in either direction add to your profit.
Let’s look back to the end of February last year
to see how a $10,000 trade in each of these three strategies
would have performed, projecting a holding period of 30 days
and an expected increase in implied volatility of 8%, at
different possible prices of the May futures contract (along
the bottom x-axis): |
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As you can see, for a straight bet on price, simply
going long the May futures contract (the blue line) would
produce the most profit if the price increases. Buying calls (the
brown line) results in less of a gain if the price increases
than simply being long the futures contract. But this strategy but
actually limits your losses relative to the long futures trade
if you are wrong and the price drops. The strangle trade
(purple line) is profitable over the widest range of
prices. You make
the least when the price increases, but if you are wrong and
it decreases substantially, you still stand to make a
reasonable profit.
How did a $10,000 trade with each of these strategies
actually perform by
March 28th, 2001 ?
The price of the May contract dropped from 217 to
209 ¼ over the month, while implied volatility increased about
4 1/2%. You would
have done best with the strangle trade, losing $1,050 (even
with the highest commissions, $1,150). Buying the call
options resulted in a loss of $5,581.25 (after commissions of
$475). The worst
performance came from going long the futures contract, a loss
of $9,900 (after commissions of $600). Remember, this is when
the price went the opposite direction of what you were
expecting. While
some traders shy away from options because they perceive them
as too risky, you can see that their versatility actually
allows you to create less risky
trades.
While
understanding past market tendencies to move in a particular
direction can be used to make informed, and often profitable,
trading decisions, traders should exercise due diligence and
use other forms of analysis in conjunction with
seasonality.
Seasonal events can be early, late, or never come at
all. Each year is
unique. Just
because a market has reacted a particular way in the past does
not mean it has to repeat this year. The CFTC, which
regulates commodity futures and options trading, has brought
actions over the past several years against brokers that lured
customers with the claim that they could earn large profits
with little risk based on predictable seasonal
demands.
* Option strategies
carry inherent risk of large potential losses. As such,
these strategies may not be suited to every investor.
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