When You Just Want To Strangle The Markets

I imagine that somewhere in a hedge fund's beautiful office building in Connecticut on Monday, when soybeans were falling 40 cents for the second straight session and the fund's bankers couldn't be reached to wire a margin call, that its still-long traders would have liked to shoot down some South American rain clouds or snip the power cords of some algorithmic-trading supercomputers.

Making strangle trades are risky. The could be profitable, but when they're not, they can mean big losses. (Photo by moyix (CC BY-SA 2.0))

By rights, a series of down days shouldn't have seemed too surprising in the soybean market, which has been on an identifiable downtrend since September when the U.S. weather threats had passed and the northern states were harvesting not-so-bad yields. However, after four months of being lulled into a relative sense of calm, it was the sudden scale of soybeans' losses that were indeed surprising. The soybean chart hasn't moved $1.20 per bushel within three days since the start of July. It's not an unprecedented move, it's just been awhile since we've been this jumpy.

In the corn market, particularly, volatility levels were starting to feel like the "old normal" (pre-2007) when the difference between a month's high price and a month's low price was frequently no more than 15 cents. During the "new normal" of the past few years, we've had monthly trading ranges as wide as $1.13 (September 2012), $1.32 (May 2012), or $1.84 (June 2011) and not really flinched. Then things got quiet and we got spoiled. In October 2012 the difference between the high and the low of the December corn futures contract was only 43 3/4 cents. Excluding February 2012, a monthly trading range hasn't been that stable since June 2010. The neutrality of the corn market has been in place for months now -- since Sept. 28, the nearby December chart has stayed within a 70 cent trading range.

When you see a market you expect to remain in a sideways pattern with low volatility for a certain stretch of time, that's an invitation to actually "strangle" the market. A short strangle is an options spread strategy that involves simultaneously selling an out-of-the-money put and an out-of-the-money call with identical expiration dates, on the idea that the market won't go above or below those strike prices before expiration, and that volatility will remain low or even decrease. The seller of an option strangle doesn't particularly care whether the market goes up or down, as long as it doesn't go too far up or down, and his short options positions expire worthless, and he ultimately gets to collect all the premium value. Obviously, it's a speculative trade (not a hedge) and a risky one at that, if the market suddenly jumps above or below one of the options' strike prices. But on Tuesday, a short strangle between a $7.70 March corn call and a $7.00 March put would have had the potential to net its seller about 43 cents of profit.

A strangle trade in corn probably looked better last week than it does now, since the December corn contract has broken through price levels where technical support was pegged (see DTN Senior Analyst Darin Newsom's Technically Speaking blog). As of this writing, it still hasn't fallen below its Sept. 28 low of $7.05 and may still be said to be within a consolidation range.

The fundamental case for strangling the old-crop corn market is all still in place -- end users cut back demand when cash corn exceeded $7.50 this summer and have balked at any futures movement higher than $7.75. So we could say there's a natural ceiling. Meanwhile, farmers have stored whatever corn they haven't already taken to market and their reluctance to sell below $7.15 has kept turning the screws on a tighter and tighter basis picture. So there's somewhat of a natural floor ... for old crop.

For new crop, the situation is entirely reversed, in my opinion. Between now and the next U.S. harvest, there is a whole opposite hemisphere's worth of grain to work its way onto the world market. If that hemisphere's production is sufficiently large, all the presently bullish stocks arguments for feed grains will go away. If that hemisphere's production is insufficient, all the presently bullish stocks arguments could become more frantically bullish than any end user wants to think about.

In a situation where you don't know which path a market is going to take, but you're pretty sure whichever path it takes will be a wild one, the opposite trade from a short strangle would be a long "straddle." The owner of a straddle buys both a put and a call at the same strike price with the same expiration date. As long as the market is volatile enough to move farther away from the strike price than the sum of what the trader paid for the two options, he'll make some profit. And his losses are limited to a known amount. For instance, on Tuesday a $13.80 May soybean call plus a $13.80 May soybean put would cost a net $1.44. Do you think that by the time May rolls around, i.e. once we know more about the South American crop, the soybean market will be at least $1.44 up or down from where it is now (either lower than $12.28 or higher than $15.17)?

These are clearly speculative plays -- taking on risk with a pure profit motive. If a farmer, who typically uses the futures and options markets for risk management goals instead of profit goals, were to make a speculative trade ... well, he wouldn't be the first. But perhaps the more crucial takeaway for a hedger would be that final question -- does he think the market is going to look wildly different in a few months than it does now? If his opinion is yes, then there are certainly a number of things he can do now so that the next time the market dives more than a dollar in three days, he won't be looking around for the nearest liquidating hedge fund manager to strangle.

Elaine Kub is the author of Mastering the Grain Markets and can be reached at elaine@masteringthegrainmarkets.com.

The above comments aren't a solicitation or recommendation to buy or sell commodity futures or commodity options. Trading commodity futures and options involves substantial risk of loss and may not be suitable for all investors. Past performance isn't indicative of future results. Opinions are subject to change at any time.

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