Market Commentary for 8/26/16
Pro Farmer finished their crop tour this week. They found that SD and OH will likely be below average due to unfavorable weather conditions, but not as much as some had earlier predicted. NE yield estimates were a little uncertain. There may be difficulties accounting for the irrigated versus dryland yields. IL and IN were extremely good while IA and MN were labelled good. Overall, I was surprised how good they thought the crop was.
Sep corn futures breached the $3.18 low from two years ago. This opens the door to test the magical $3 level, which has been unseen since 2009. Wheat traded well under $4 for the first time in 10 years. No one knows when the low will happen in corn. It could be like the summer run-up where the market may over-run to the low side before bouncing back up. The early harvest reports may have a big impact yet on market direction.
The trade is trying to determine final yields and will be relying on early harvest reports. Right now most trade estimates are between 171 and 173. Farmers are hoping for <170 to help drive prices higher.
Understanding Stocks to Usage Ratio (Carryout/Total Demand)
Many people are discussing the high demand for U.S. corn as a possible rationale for increased prices. While this may happen, farmers also need to consider potential carryout levels, which will likely be the highest since 1988 this year. Often the Stocks to Use Ratio considers both of these factors’ impact on prices.
Current carryout projection based upon the 175 USDA yield is 2.4 Billion and 14.5 Billion usage/demand = 16.6% Stocks to Use Ratio
Historically, the Stocks to Use Ratio has not been this high since the ethanol mandate of 2007. Actually, the last time it was over 17% was 2005 when prices were $2/bu. It was between 13% and14% in 2008 and 2009 when prices went from $4 to $3. Last year and the year prior, it was around 12.5%. In 2012 (7.5%) and 1996 (4.9%) Stock to Use Ratios were very low, and corn prices hit historical high levels. A 168 yield would make the Stocks to Use Ratio around 12%, and may justify a rally back to $4.00, but I’m not sure that low of a yield is realistic based upon crop tours.
It could mean a yield of 175 brings $3 while 172 is $3.50 and 168 is $4. However, the final number will come on January 31 and accurate field yield estimates won’t be ready until mid-October. There is a lot of time for this market to continue sideways action. Personally, I think any bullish talk right now is built up on fundamentals that aren’t justified. The market may still trade lower. Lack of farmer selling may help prices from tanking a little, but the funds can still push this market lower.
Weather has been favorable for beans lately. Also, demand has been strong. If bean yields exceed USDA estimates and many in the trade feel that is very possible right now, the market will be saturated with heavy supply which leads to a big carryout. If for some reason demand reduces later in the year because of a large South American crop, beans could implode on themselves.
Buying vs Selling Calls
In April I heard brokers recommending that farmers sell cash grain and buy Sep calls. At the time, buying a Sep call cost around 20 cents.
Why do farmers buy calls?
Most of the time farmers do it because they think prices will go higher. They don’t want to risk missing a potential high. It rarely makes sense to me. Farmers have substantial new crop they need to sell if there is a rally. Buying calls adds more risk to their operation and usually doesn’t bring the profits they think they will get. It’s a speculation trade.
What happened to those who bought these calls?
Following is a chart that shows the history of the Sep $4 call option since December of 2015.
Calls vs Futures
Calls do not increase at the same rate as the futures market. In Feb the market was about $3.80. It hit $4.40 at its high in the summer (a 60 cent rally indicated by the red line). However, as the first chart shows, the value of the call only rallied 30 cents during that time. Then within 3 trading days the call lost all of its profit. I doubt many farmers who bought these calls sold them at the high (or even at a profit).
The problem is that many farmers don’t take into consideration the variations in movement between calls and futures when determining potential profits when buying calls. In this case, the call only moved 1 cent for every 2 cents the market increased. This meant the market would have had to rally over 40 cents from $3.80 to begin to make a profit on the call, after reaching $4.20.
So why do farmers buy calls then?
Selling grain and buying calls guarantees a floor and provides upside potential. However, buying potential is a guaranteed loss if profit isn’t taken. While I admit buying calls works occasionally, the reward never justifies the frequent misses (i.e. risk) in the long run.
Farmers must always remember that they will have more grain to sell in no more than 364 days at any point in the year. Farmers always need a market rally, because they always will have more grain to sell. So, it doesn’t make sense to bet on it twice by buying calls.
Why are you bringing this up?
Because I sold calls during this same time period and picked up some premium in the market.
I thought the recommendation to buy Sep calls in April was risky and bad advice. Considering the information at the time, a sideways market through the summer seemed the best case scenario. So, I sold some calls. The red Xs in the above charts are where and when I sold the $4.00 Sep call. In both cases I collected nearly 20 cents of premium when many farmers ended up losing money buying those calls.
The Sep corn calls expired this Friday.
What’s your strategy when selling calls?
I prefer selling calls when markets are moving sideways. Since selling calls doesn’t provide downside protection I have risk if the market goes lower, like it has in the last 45 days. However I never have all of my grain set up for a down market. Sometimes the market goes nowhere and I need to capture profit from that situation.
So what do you do now?
The three calls expired worthless Friday, so I will need to do another trade because I’m not happy with prices today. But, I’m not really happy with where they might be in the next few months. So on Monday when Dec futures were at $3.42 I….
What does this mean?
If the market continues to trade sideways (or falls) into harvest, then I will collect the above premium and apply it to a later trade. This could give me about 30 cents average of premium on 15% of my production PLUS the 20 cent premium I just collected on 15% of my production that expired on Friday. This would mean I could have an extra 50 cent premium going into spring that I can apply to a future sale of the old crop.
What if the market is above the strike price at expiration?
My call strategy involves selling 2 calls at each strike price instead of just 1. Normally, I’m never a fan of selling 2 to protect 1. However, sometimes the market presents an opportunity that can make you additional money if the market moves in one direction, and doesn’t hurt you too much if it moves the other way. In this case, if the market moves above the strike price at expiration, then I will have to make 2 sales at each strike price. Meaning I have to sell 3.30 and 3.40 type of levels.
Why would you even think of selling any additional bushels at 3.30 or 3.40 when we are so far below the cost of production?
I’m behind in my 2016 sales. So, while I’m not thrilled with this sale, I can live with it. Currently, 70% of my 2016 corn crop is hedged and I’m usually over 90% by this time. Also, as stated above, I expect a sideways market until Thanksgiving.
But, what if the market rallies?
Many farmers and some in the trade expect corn futures to rally. I also expect futures to rally, but I don’t think it will happen during harvest. I’m expecting any large rally to happen in the spring.
Regardless of what I think will happen, I still have to be prepared if the market does rally. I want to be as prepared as possible for ALL scenarios when I put a trade in place. If there is a rally, then I am committed to selling 15% of my crop at a $3.51 average against Dec futures (Avg $3.365 futures + half of the premiums from above which would be $.145 ). Plus, I will also add the 20 cent call premiums that expired Friday to this trade making it – $3.71 against Dec futures. From there I will apply market carry which is currently 24 cents to hold the crop until next summer to the trade. I could be just under $4 on this 15% of 2016 corn.
But, I have to make an additional sale at $3.365 average futures and apply the other ½ of the premiums of $.145. I plan then to move this sale to my 2017 production. The market is currently trading at nearly 40 cents premium from Dec of 16 to Dec of 17. So my trade becomes a $3.91 sales for next year ($3.51 + .40). Not the best trade, but a reasonable place to begin sales for next year.
One more corn option trade for the 2017 crop…
I sold a $3.50 call strategy against March futures that expires 4th week of Feb for a 48 cents of premium on what will like be only 5% of production
Summary of the Trades
It’s important to remember that all of my trades are based upon an overall marketing strategy for the year. Each decision I make is either based upon past trades or trades I plan to place further in time. While it may not be the right time to sell right now, I don’t know when the right time will be to sell (no one does). I think there is a lot of rationale for why the market will trade sideways or lower in the short-term; therefore, I am making trades that bring premiums against that scenario, while still being mindful of what I will receive if the market does rally.
These trades are extremely complicated if you haven’t traded options frequently, so think of it in baseball terms….I’m basically “manufacturing a run” in baseball. Right now it’s the 7th inning and I’m behind by a run with a runner on 1st and 3rd. These trades are like bunting to advance the runners. I could end up in a double play (because the market rallies). However, there is a good chance I could tie, or even take the lead going into the 8th inning (i.e. this trade is successful — because the market stays sideways in the short-term). The last thing I want to do is sit around waiting and doing nothing, hoping for a home run to save me in the 8th or 9th inning that may never come.
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