February 16, 2009

Chicago Board of Trade soy prices have been volatile, given bullish weather in South America and strong demand from China, leaving the opportunity for big gains - or losses.

 

Because of these factors, trading strategists are encouraging market users to incorporate options strategies into their risk management programs.

 

Since the start of the New Year, most-active March soy futures have jockeyed within a wide trading range from the January 12 high of US$10.60 1/4 to the February 3 low of US$9.34 1/2. The movement comes after soy rallied nearly US$2 a bushel in December.

 

Volatility has been high during this run, and market advisers and traders are looking at options as a viable alternative to trading risk. The uncertainty of global economies is also raising questions about near-term market outlooks, leaving producers, end users and speculators looking at options to limit risk exposure.

 

Options on futures are the right, but not the responsibility, to buy or sell at a fixed price in the future.

 

The volatility and speculative-led rallies have pushed a lot of hedgers into options, as they allow end users to better define the amount of money needed to put on hedges, analysts said.

 

Volatility is a measurement of the change in price over a given period. It is often expressed as a percentage and computed as the annualized standard deviation of the percentage change in daily price.

 

In the midst of a "great recession," it is paramount that producers use options to lock in costs, said Mike Zuzolo, an analyst with Risk Management Commodities Inc. in Lafayette, Ind.

 

New crop implied volatility has ranged from 40 percent to 50 percent so far in February, levels not usually seen until mid summer, Zuzolo said. Volatility for at the money November strike prices should be 25 percent to 30 percent at this time, but is running above 41 percent, he said. The US$9 November call option is trading at 58 percent implied volatility.

 

"This is a tricky year for producers, and options make a lot of sense due to the uncertainty, but you will have to pay higher option premiums due to higher implied volatility," Zuzolo said.

 

Crop insurance levels are based off prices in February, Zuzolo said.

 

A lot of producers feel they are selling cash supplies into a hole and are waiting for another price bounce.

 

"The market does not, however, have the demand strength seen in recent years, and market participants can't expect the index fund rallies that emerged in recent Februarys, due to less capital available in the market place" Zuzolo said.

 

Large investment banks have seen sizable reductions in market capital from 2007 to January 2009. Market capitalization is down from US$255 billion to US$19 billion at Citigroup Inc. (C). JPMorgan Chase & Co. (JPM) is down to US$85 billion from US$165 billion and Goldman Sachs Group Inc. (GS) is down to 35 billion from 100 billion, according to analysts.

 

In recent years, fund-led rallies rewarded farmers with higher crop insurance baselines, insuring them with a higher per revenue price of protection. "The lower the price, the less insurance you need and the more you need to use options," Zuzolo said.

 

The selling of calls is a bearish strategy that could be useful. The seller would take advantage of the premium sold and could generate revenue as the decay on option premiums steadily erodes heading toward the June and July time frame. Premium is the amount paid above the normal price. In this case, the seller is betting prices will fall between now and then.

 

Volatility calendar spreads can be an effective tool constructed to be bullish or bearish. The strategy of selling front month puts or calls and buy back month puts or calls takes advantage of the spread between old-crop and new-crop volatility, analysts said.

 

All front month calls and puts have become expensive in comparison to back month options, making the volatility spread an attractive tool over the course of the market's latest bullish run.

 

Farmers who want to make cash sales should use some type of options out to the July strike to cover the cost of interest and storage, said Brian Hoops, president of Midwest Market Solutions in Yankton, S.D.

 

"If a producer is looking to unload cash supplies, buy calls, but if they hold onto their cash supplies, they should buy puts," Hoops said.

 

There are numerous other options strategies that could be useful for individual needs. Using the various tools available during heavy price fluctuation only serves to improve the risk management of speculative objectives of traders and market hedgers alike, analysts said.