Use this Alternative to Stock Market Strategy to bring uncorrelated income to your portfolio
Former commodity hedge consultant reveals the “Alternative to Alternatives” for individual investors
by Don A. Singletary (guest contributor)
With the S&P 500 hitting dizzying levels this summer and interest rates near zero, alternative investments are once again the hot topic with investors. But all alternatives are not created equal. In fact, many better-known alternatives have proven that different is not necessarily better.
This table reveals how selected alternative investments have done over the last 1, 3 and 5 year periods. Only three of a dozen categories have faired well, the S&P500, real estate, and the First Trust U.S. IPO ETF. The results overall are pretty dismal.
All returns through may 31, 2016 – Source: Morningstar with special thanks to Ben Johnson
Alternative investments are easy to find; the industry is always creating more of them to sell to the public and institutions; as a commercial TV phrase says, “this is what they do”. Personal investors understand the need for diversity but they also understand how too much diversity can dilute results. It is very much like being ‘insurance poor.’
There is a way to break the diversity doldrums; but it requires a new look at the things we take most for granted.
“There are these two young fish swimming along and they happen to meet an older fish swimming the other way, who nods at them and says “Morning, boys. How’s the water?” And the two young fish swim on for a bit, and then eventually one of them looks over at the other and goes “What the hell is water?
The point of the fish story is merely that the most obvious, important realities are often the ones that are hardest to see….” – David Foster Wallace in his 2005 commencement address at Kenyon University.
In my workshops and writings, I often borrow Wallace’s ‘fish story’ to encourage investors to consider an alternate strategy, rather than just considering different assets. Many option strategies do not depend on exact price forecasting; it’s more a matter of determining where prices won’t go, instead of where they will go. The right strategies and timing can often transcend the need to out-guess price movements.
About 80% of options on stocks and commodities expire worthless, so selling them and collecting the money (premium) makes sense. These are great odds, but not nearly good enough for truly savvy investors. The pros take it a step further as you will see in the following example. Investing in a smarter way, requires that we take every possible advantage – to find even higher favorability for a trade. I’ll show you a popular strategy the pros use, with this recent and real example.
Chart: Seasonal Patterns in Corn Futures: Peaks during Spring/Summer, then price drops into Fall Harvests
HOW THE PROS DO IT
Think of this approach as trading in harmony with Mother Nature, like sailing with the wind instead of tacking against it. In commodities like corn and wheat, planting and harvesting cycles are determined by nature. The months when the ‘new crop’ is at most risk – are between spring planting and the fall harvest. This higher risk to the crop, often translates into higher prices. On the chart, you’ll see the seasonal corn price peaks for the last three years. In North America, April – July is usually the maximum risk time. This is the season when the USA crop is most vulnerable to drought, flood, temperature extremes, and other risk factors that can effect pollination and yield.
The USDA regularly issues key data including acreage plantings, yield, crop conditions, and reports the stocks volume. To a trained and experienced eye, this very important data reveals the likelihood of adherence to seasonal price patterns. This in turn, allows an evaluation of option values in relation to seasonal patterns of price and implied volatility. Since the US is an exporter of corn, fluctuations in currency exchange rates can be a major factor in pricing. A stronger US dollar makes corn cost more for countries that are buyers – and all of this, of course, influences demand. The Brexit vote in summer of 2016, resulted in a stronger US dollar; this contributed to the decline in corn prices. (For brevity, not all the price factors are discussed here.)
The trade that I placed based on this information was selling the September 2016 CALL options with a $5.00 strike, and I placed the trade when Corn was priced at $4.30 per bushel the first week of June 2016. Over the next few weeks, Corn prices dropped a dollar or more (On July 27th, SEP16 Corn traded at $3.35/bushel) – and I (and a great many other investors I’m sure) – closed the trade for a tidy profit. We did it by buying back the options we sold for a high price, at a much, much lower price to ‘close’ the trade as we pocketed this difference in price.
The new sophisticated online trading platforms and the introduction of agricultural options since the early 1990’s have created opportunities in selling far OTM options on selected commodities. For more than 25 years, I worked as a private consultant to major corporations that used these ag options in their hedge programs. Every trading day, options are sold to speculators who are trying to make their fortunes with high risk trades by buying these options. Companies and individuals regularly sell these options to those high-stakes speculators. In my work, we often sold risk to speculators and collected their money to add to our profit margins. The job was to sell risk, not buy it, the very purpose of a risk management account.
Any type of option writing has risks, there is no way to avoid it. Trade selection, the right strikes at the right time, and understanding the seasonal price and implied volatility patterns – are all critical to this type of trading. What I find perhaps most amazing is that the mechanics of this type of trading are very straight forward. Even though it takes knowledge and practice, this strategy is really an exercise in common sense.
"If you can’t explain it simply, you don’t understand it well enough." – Albert Einstein
Always use options far enough OTM, so that if things don’t go your way, you have plenty of room to unwind the trade. The concept is very basic: Use your option knowledge in harmony with Mother Nature, don’t be greedy, and understand that you don’t have to win every trade to be a winner.
I’d like to point out that, while this is not a starting place for new investors, the principles are not inherently difficult to learn. The new vocabulary of terms and the mechanics of trading commodity and stock options will take an investment of time and effort. (There is no free lunch, you know.) Due to time restraints, many investors choose to have these investments managed by professionals, or they team up with a broker who specializes in these trades. This strategy is easy to understand and execute for those willing to do the work. Simple is always better. Perhaps a change in strategy is all you need in order to work smarter.
I am very grateful to my mentors over the last two decades, who were generous and kind enough to share these lessons with me. At the top of this list, the late Phil Herndon – a good friend to me and so many others. – Don Singletary
Don A. Singletary is a guest contributor to OptionSellers.com’ s blog. Don was a corporate teacher and commodity hedge manager for major corporations for 25 years. His recent book is an introduction for beginning and intermediate level traders of options. It is highly praised for its plain language and common sense approach to option trading. The title is: Options Exposed Playbook – The Most Profitable and Popular Online Option Strategies of All Time. The book is available at www.Amazon.com.