How to Take Big Premiums From Weather Markets Now
Michael: Hello, everyone. This is Michael Gross from OptionSellers.com here with your August edition of the Option Seller Podcast and Radio Show. James, welcome to the show this month.
James: Hello, Michael. Glad to be here and always fun to do.
Michael: We find ourselves here in the middle of summer and, of course, summer weather often times can take headlines in the agricultural commodities. That’s what we’re going to talk about this month. We have several things going on in some of our favorite agricultural markets. In the Northern Hemisphere, of course, we have growing seasons for crops, such as corn, soybeans, and wheat. Down in the Southern Hemisphere, we have winter time, which is actually an active time for some of the crops they grow down there because you have crops like coffee and some of the other countries, cocoa, that aren’t planted every year. There’s trees or bushes that tend to bloom every year, so winter can often be a time to keep an eye on those, as well. James, maybe to start off here, we can talk a little bit about weather markets themselves, what they entail, and why they can be important for option writers.
James: Well, Michael, many, many years ago, my introduction to commodities investing/trading came along in the summer. There was an incredible hot spell and dry conditions in the Midwest in the United States right during pollination time. That was my introduction to commodities and commodities trading. Weather markets, especially in sensitive times like July and August for the Northern Hemisphere, certainly does bring a great deal of volatility to prices and great opportunity for a weather market to grab hold of particular prices, and that was my introduction into the commodities trading. I’m quite sure that, as summer heats up, of course, here in the United States, so does trading and certain commodities and it looks like we’ve hit that start up again in 2017.
Michael: Okay. Being in these markets as long as you and I have, we’ve seen our share of weather markets. After a while, most of them tend to follow a typical pattern. You see a weather scare, you see prices rise in some commodities, and prices tend to immediately price-in a worse case scenario and then you get the real report or then it rains or whatever happens, and then prices tend to force the back-pedal… not always, but most of the time that tends to be the case. If there is a price adjustment upwards necessary, prices will often do that, but often times that spike often comes in that initial wave of buying, and that tends to have an affect on some of the option prices. Would you agree?
James: Well, certainly a lot of investors who trade seasonally, or perhaps had taken advantage of weather rallies years before, they will look at the option market. Generally, they are not futures traders, so what they might do is they’ll say, “Well, if the price of cotton or the price of corn or soybeans might be going higher because of dry conditions, lets see what options are out there for me to buy.” I would say that the biggest spike, not only in prices, but in prices for call options, particularly, often happen during these weather phenomenons, and so be it. The call buying that comes into the market during these weather patterns. Usually, as you mentioned or alluded a moment ago, it usually winds up being the high as the public pours into the market. It has happened many times in the past and seems to repeat itself time and time again.
Michael: Yeah, that’s a great point, too. You’re talking about that you have a lot of the general public who love to buy options, the media loves to pick up on weather stories and the public reads it, and it tends to feed on itself, and you have public speculators coming in that are buying up options, often times deep out-of-the-money options. These are often times that people who know the fundamentals want to take a look at that and say, “We could take a pretty good premium here with pretty reasonable risks”, and that’s obviously what we are trying to do and what people listening to us are trying to do. So, why don’t we go ahead and move into our first market because we do have a few other markets to talk about this month. First market we’re going to talk about is, actually a couple markets, is the grain markets as a whole, corn, soybeans, wheat, all being affected to some degree by some of the weather. These aren’t raging weather markets, it’s not on the national news, but they’re enough to get those option values up and certainly enough for people listening, or our clients, to take advantage of. When we talk about these, I think we’ll probably focus on soybeans and wheat for this session. As we talked about in our newsletter and in our blog, there has been some drier weather, especially in some of the northern growing regions up in the Dakotas. Recently, I read a little bit about it possibly moving down into Illinois and further into Nebraska. So, they’ve had some dry weather and this has had a particular affect on wheat, but also on soybean prices. Maybe you can just explain how that worked and what transpired there to push those prices higher.
James: Michael, it seems that a weather market can come in just practically any portion of the United States. Years ago, Illinois, Indiana, and Iowa, that was the extent of the corn-belt, with fringes of Wisconsin and Minnesota. With high prices in commodities over the last several years, some of the other areas of the United States, people started planting corn, soybeans, and wheat, as you mentioned. This year, the extreme heat and dryness is in the Dakotas, usually not an area that moves the market as much, but this year it did. I know the media really got a hold of the dry conditions and discussed North Dakota and South Dakota, some of the hottest, driest conditions in over half a century. I know I had CNBC calling practically every day to talk about the weather. That is what gets these markets moving, and it usually happens this time of the year. You alluded, once again, to something that happens often is you’ll have these headlines really create havoc with some of the markets and pushing them higher, but, lo and behold, some 95% of the crop is really untouched as it is in decent growing areas as far as the weather goes. As you get into harvest time, a lot of that talk is now behind them and people forgot about the weather in North Dakota and South Dakota 6 months later. That seems to be developing again this year. We’ll have to wait and see how that plays out.
Michael: That’s a great point. Probably we should point out here the backdrop of what this weather market is operating in. Exactly what you described is happening, of course, you have speculators buying soybeans off of the dryer weather, buying call options off the dryer weather. As of the last USDA report, 2017-2018 ending stocks are pegged at 460 million bushels, which is going to be the highest level since 2006-2007. So, we’re going into this with a pretty burdensome supply level. Now, if there is some reduction in yield, yes, that could come down a little bit – something to keep an eye on. You also have global ending stocks 93.53 million tons. That’s pretty substantial, as well. You’re operating on it being a pretty hefty supply environment. At the end of the day, when we go into harvest, prices tend to decline, regardless of what the actual supply is because that’s when the actual supplies are going to be the highest regardless. We’re fighting that big picture of, “We already have hefty supply and we have a seasonal working against the prices here.” So, two reasons why people listening may want to consider selling calls when you do get weather rallies like this because the bigger picture is not that bullish. Secondly, one thing to point out here is we’ve had problems with dryness up in North and South Dakota, possibly coming a little bit further south, latest weekly crop condition report is a 4% decline in good-excellent rating. They’re starting to reflect some of that damage, but one thing to remember is this happens often. It happened last year. It happened a couple years before that where it was dry in July and everybody was talking about weather. Then, they’re talking about pushing yields back a bushel or two an acre and then it rains in August, then all the sudden we have above average yields. So, you have prices right now that can, you can get a little pop or you can also see them roll over. I know you have a favorite strategy for playing markets like that.
James: Well, Michael, we wait for volatility to come into the different markets that we follow. Certainly, a weather market in summer is one of those. Probably the best way to approach selling options, whether it be calls or puts in a weather market, is to do it with a covered position. Basically, a strategy that we cover in Chapter 10 in The Complete Guide to Option Selling: Third Edition, it’s really an ideal positioning for weather markets. Basically, what you’re doing is you’re selling a credit spread where as you are selling whatever item you think that the market can’t reach, for example, soybeans this year trading around $10 a bushel based on supply and demand probably won’t be reaching $12.50 or $13 a bushel. What you might look to do is do a credit spread where you buy one call closer to the money and sell 3, 4, or 5 calls further out. The one long position is basically insurance on your shorts so that while the weather is still in the news and while there is still quite a bit of jitters as to how much crop potential we might lose this year, that holds you in the position. You’re basically short with just a little bit of protection and that really does a great job in riding the investor through weather markets and if you are fundamentally sound on your picture of what the market will likely be, as you mention, we have some of the largest ending stocks in some 10 years, you do want to be short this market at harvest time. By applying a credit spread in July and August is a great way to get involved with the market and protect yourself while you’re waiting for the market to eventually settle down.
Michael: When you’re talking about and referring to the ratio credit spread, that really eliminates the need to have perfect timing. Of course, all option selling you don’t really need perfect timing, but that really helps out. If you do get a rally, those can be opportunities for writing spreads just like that. If you’re already in it and the market rallies, you have that protection, a lot of staying power there, and when the market eventually does turn around there is a number of different ways you can make money with a ratio spread. Of course, at the end of the day, we want them all to expire. Talking about soybeans right now, this does not look like any type of catastrophic yield loss or anything like that. This looks, at the most, if we get something, they might get a few bushel break or reduction prices may need to adjust a little bit higher, but in that case sometimes a ratio spread can work out even better. Is that correct?
James: Well, Michael, it’s interesting. Your long position, for example, in soybean calls or corn calls or wheat calls, there’s a chance that that thing goes in-the-money and your short options stay out-of-the-money. That certainly is an ideal situation for the ratio credit spread, where, basically, the market winds up being between your long options and your short options. That happens rarely, but, boy oh boy, is that a great payday when it does happen. That’s not why we apply the ratio credit spread, but every once in a while you get quite a bonus. That describes one extremely well.
Michael: All right. Let’s talk about wheat just a little bit. A lot of the same things going on in wheat, but wheat is affected a little bit differently than the beans, primarily because we have a lot more wheat grown up in those regions where they’re having the trouble. In fact, I read here, as far as the drought goes, North and South Dakota, I don’t have the stat here in front of me, but it’s somewhere between 72-73% of the acreage up there is considered in drought right now. So, a lot of wheat is grown up there. At the same time, that’s one of those markets that may have priced in a worse case scenario and now backing off. What do you think?
James: You know, the wheat market probably, it does have different fundamentals than corn and soybeans, clearly, it has rallied over $1 a bushel, which would have been about practically 25% when a lot of the discussion about the Dakotas was taking place. The wheat market looks like it’s priced, you know, the heat and dryness already in. Of course, one thing about the wheat is it’s grown in so many locations around the world that if you do have a loss in production in the Dakotas in the United States, there are many places around the world ready to fill in for any loss in production. All around the world wheat is grown in probably near 100 countries… certainly different than corn and soybeans.
Michael: You made a great case for that in the upcoming newsletter, too, the piece about wheat, where all this talk about loss of yield to the spring wheat crop, but that only represents about 25% of the overall U.S. crop. Most of the crop grown here is winter wheat, which wasn’t as heavily affected. The bigger point is the one you made just now. This thing is grown all over the world. The United States only produces about 9% of the wheat grown in the whole world. Right now, world wheat ending stocks are going to hit a record level in 2017-2018. So, again, you’re looking at a little news story here, but when you look at the bigger picture we are going to have record world supply of wheat this year. Again, these can be opportunities for writing calls for when those bigger picture fundamentals start to take hold. It can certainly help your position.
James: Exactly. This year, I think, was another great example of that. Ending stocks possibly being records. It’s almost an ideal situation when weather problems arise because later on that year, lo and behold, we have more wheat than we need and the price goes back down. Weather rallies, whether it’s the Southern Hemisphere or Northern Hemisphere, really often plays into the hands of option sellers because the buyers come out of the woodwork and normally, you know, holding the short end of the stick come harvest time.
Michael: We should find out where everything plays out in the next USDA supply/demand report. I believe that is on or around August 10th. That’s really going to reflect what the real picture is, if there was yield loss, and how much of it was. If it’s less than traders thought, prices probably roll over and we’re probably done because you have soybean podding in August and markets typically start declining after that anyway. If we do get a little bullish surprise, we’re not saying the market can’t rally if you’re listening at home and saying, “I need to go hands-in short right now”. The market can rally, especially on or around this report if you get a bullish surprise. What we are saying is those can be opportune times to write options, because that’s when that volatility will jump and, overall, the bigger picture fundamentals remain bearish. James, we’re going to talk here a little bit about our next market, but before we do that, anybody listening to our conversation here about the grain markets this summer, you’ll want to read our August issue of the Option Seller Newsletter. That comes out August 1st. It will be received electronically and it will also be available on hard copy newsletter in your mailbox if you’re on our subscriber list. We have a feature article in there on wheat. We talk about credit spreads, some of the things James and I just discussed here, and how you can apply them. It is a great strategy for this time of year and you can read all about it in the August newsletter. If you aren’t a subscriber yet and you’d like to subscribe, you can subscribe at OptionSellers.com/newsletter and read all about it. James, we’re going to move into our next market here this month, which is one of your favorite markets to trade, that is, of course, the coffee market. I know you’ve been doing work with Reuters World News this month back and forth on the coffee market and what’s going on there. Maybe give us an overview of what’s happening in the coffee market right now.
James: Michael, it’s interesting. As all of our intelligent readers and watchers already now, as temperatures heat up in the United States, they are definitely cooling off in the Southern Hemisphere, Australia and Brazil for example. What so often happens for traders in the coffee market, they look at winter approach in the Brazilian growing regions and they remember back to when coffee supplies were really cut based on a freeze that developed in Southern Brazil. During those periods, some 1/3 the coffee crop that Brazil makes each year was grown in very southern areas of Brazil, which are prone to cold weather. Chances are freezes don’t develop in the coffee regions of Brazil, but just like the dry weather in the United States a lot of investors and traders want to trade that idea of it happening. That’s what’s going on recently as we approach the coldest times of the season in the Southern Hemisphere. Traders and investors are bidding up the price of coffee and, likewise, buying calls in the coffee market, planning on maybe some adverse weather taking place. I think we all hear about El Niño and La Niña and what that can do to temperatures, both north as well as south, and a lot of investors, if something like that takes place, they want to be in on it. Often, how they do get involved with that is by buying calls in coffee, cocoa, and sugar, and it looks like that’s what’s pushing up some of those soft commodities today.
Michael: Okay. So, they’re buying it primarily on freeze-type thing… same type of thing going on here in reverse. Instead of hot weather, they’re betting on cold weather. Talk a little bit about the bigger picture there as far as what supplies are like, what they are buying here.
James: Well, Michael, it’s kind of interesting. It’s almost like a carbon copy of what we just discussed on the grain and grain fundamentals. Coffee supplies in the United States, which, of course, is the largest consumer of coffee in the world, are counted each month. Here in the United States, we have something called green coffee stocks. Obviously, that is the coffee that is then sent to roasters. Roasters roast the bean and then turn it into everyone’s favorite morning brew. Green coffee stocks in the United States are at all-time record highs. That fundamental is something that just is very discernable and is not going to go away no matter how many coffee shops spring up in your city or your town. We have record supplies in the United States. As far as the fundamental of new production, especially in Brazil, last year we had a rally in coffee prices because it was dry conditions during some of the cherry season in Brazil, and this year is just the opposite. We’ve had extremely favorable weather conditions. We have an excellent coffee crop that’s being harvested right now in many parts of Brazil and Columbia, and coffee supplies that will be coming in from the producing nations will be more than plentiful as we get into August, September, and October when those harvests wrap up. So, we have practically record supplies around the world, we have excellent growing conditions in the largest producer in the world, being Brazil. This year is what’s called an off-cycle year. A coffee bush, if you will, produces more cherries on one year and then slightly less the following year. This being an off-cycle year, still we are expected to have a record production figure in Brazil for an off-cycle year. There are already estimates for next year’s crop being in excess of 62 million bags, which would be an all-time record. For those of you who are unfamiliar with what 62 million bags of coffee might represent, Columbia, always thought to be the largest coffee producer in the world, they only grow approximately 10-12 million bags each year. So, all of the extra demand for coffee recently over the last several years from all the coffee shops springing up, Brazil has taken care of that and then some, just basically blanketing the world with extra coffee beans. That is what has kept coffee prices, really, trading near-low levels. Many commodities have increased with Chinese demand that everyone is familiar with over the last several years, but coffee is not the case. Record supplies here in the United States and record production down there from our friends in Brazil.
Michael: Yeah. I saw that, too. Brazilian Ag-Minister was 62 million bags. That’s a huge crop. Another thing I should probably mention there is that coffee has a seasonal, as well. It tends to start coming off into when harvest starts and our springtime as they head into fall, which is March-May period. Is that correct?
James: It is. Generally, the coffee crop is so large and so widespread there the harvest lasts practically 4-5 months. Basically, what you’ll see them do is often sell coffee twice a year in great strides. One is as the end of harvest approaches and then when we’re looking at next year’s crop, May and June, when they can get a handle on how large that crop is going to be, they will then start forward selling that year’s production. So, really there’s two waves of selling from coffee producers in Brazil. Usually it’s August-September for the current harvest and then May-June for the upcoming harvest. Really two large swaths of sales from Brazil, something we’re expecting to happen probably for at least the next 2 years and then we’ll have to take a look at how the conditions look after that. The next 24 months, we’re going to see a lot of coffee hit the market twice a year, those 2 times especially.
Michael: I did notice, this year the coffee market does appear to be following seasonal tendency. You know, we started seeing this last round of weakness right about March and it has dropped, so far, into June. We get a little bouncier now maybe just because prices were just so oversold and then we had the weather issue that you spoke about, as well. I know, right now, with prices in the position they are similar to what we talked about in wheat and soybeans, where you had a little bit of a weather issue at the same time big picture fundamentals still looking pretty bearish. What type of strategy are you looking at in coffee right now?
James: Well, Michael, we have coffee prices in the mid 1.30’s, approximately $1.35 per pound. Chances are we are going to be rallying maybe 5-10 cents as we go further into the winter season in Brazil, as some investors take a chance on coffee price rally. We could see coffee prices in the mid $1.40 going into August and September. We are targeting contracts 6 months out- 9 months out to take advantage of the long-term bearishness. We never want to play a market on a short-term basis, we don’t want to predict where coffee’s going to go the next 2-4 weeks. What we want to do is take our long-term fundamental analysis of the coffee market, the production and supply that we’re looking at here the next 24 months, we’re going to take a long-term view of coffee… a long-term bearish view. We are able to now sell coffee calls at $2 a pound if you go out a little bit further, another 30-60 days, you can sell coffee options at $2.20 a pound. If we do get a decent rally here in the next 30 days, which is possible, we’ll be looking at selling coffee calls at $2.40 and $2.50 a pound. Later this year, we do expect coffee prices to be around $1.20-$1.25, and there’s a pretty good chance the options we sell are going to be double that level, certainly something we’re extremely comfortable with and we think is going to work out quite well. We’ll have to wait and see. There’s no guarantee in this market or any other, but we do like our chances at selling coffee at that level, for sure.
Michael: That far out-of-the-money is exactly the target options that we talk about in The Complete Guide to Option Selling. It’s our third edition of our flagship book. If you would like to get a copy of that, you can get it at OptionSellers.com/book. You’ll get it at a discount to Amazon or bookstore prices. James, for our lesson today, I’d like to directly address a question that we get periodically from newsletter readers and listeners to this show and some of our other videos. I know a lot of people listening to this, they’re watching what we talk about and then they are taking our trade and trying to do it on their own. That’s certainly fine and there’s nothing wrong with that. That’s part of the reason we’re here, is to help people learn what this is and how to do it. A question we get is, “I saw your video/read your article and you talk about selling a strike, and I went and looked at that strike and it’s not the same premium you said,” or, “ I went and looked at it and there’s no open interest there”, or “That platform doesn’t have it. I can’t see it. How are you selling these things?” There’s a couple different answers to that. I’m going to give one and I know you probably have a better one, but one of the first reasons is a lot of the platforms they’re on they don’t carry options that far out. I know some people have mentioned Thinkorswim platform or TD Ameritrade where they only go a few months out with the commodities options. So, first and foremost, you need to get yourself a better platform so you can get further out strikes, and secondly, James, the one thing you pointed out clearly in this month’s newsletter is a lot of times when you’re talking about these things, whether here or on your bi-monthly videos is, you’re giving examples of how this could work, how it should work, what might happen if prices rally, these are the areas we target. We’re not here to give specific trade recommendations for people to take and trade tomorrow. These are examples for people to learn either if they want to invest their money this way or if they want to take the information and think and reason it on their own what to do. So, when we talk about a strike, that could be a trade we’ve already done, could be that it’s passed now, or it could be a trade we’re hoping to do if the right situation sets up. So, you just gave some pretty good examples right now and you probably agree with me there, but there’s another reason that we can target those type of strikes that other people might not be able to do, and maybe you want to talk about that.
James: Michael, that is a great point that you bring up. When I’m speaking to new clients, when they first open their account, the one question that seems to come up very often is, “James, I understand how this works, I’ve read your book, I’ve read your material, but who in the world is buying these options?” That is certainly a question we often get. By no means do I claim to experience the very best way in selling commodities options. I’m not sure what the very best way is. I just know what works for us and really being the option selling leader, I certainly believe we are, we are selling options in quantities that practically no one else in the world is. We have the luxury of selling gold options to banks in London and New York, we have the luxury of selling options in the crude oil market to energy companies, and it’s quite possible that when we’re selling options distant strikes coffee, we are likely selling them to coffee companies, like Starbucks and the such, a lot of popular names that a lot of people now. When you’re selling to contracts for your particular own personal account, you’re probably not going to get a chance to deal with London banks or other large coffee companies, but when you’re selling options in very large gross volume, these companies do want to work with you and they do want to listen to you. That opens up these strikes to us.
Michael: That’s a great point. Maybe for just some of our listeners that may not be familiar with how that is, it’s not like James is getting on the phone and calling somebody in London and Citi Bank and asking them if they want to buy our options. These are still going through registered exchanges, it’s just a different path we are taking through them where we are working through specialized order desk. These people have relationships with other brokers for these organizations, but the trades are still done on the registered exchange, correct?
James: Yes, they definitely are. It’s just relationships that our clearing firm has established and it’s something that, I feel, just the pinnacle of option selling… having those relationships in place and when you need and want to sell options that are further out in time, as maybe some of our listeners or readers have asked about, that’s something we have the luxury to do and we certainly want to take full advantage of that by selling to some of the largest banks or some of the largest companies that are maybe end users in coffee or in sugar or in soybeans. It’s quite a luxury we have working with those relationships that our clearing firm has already built for us.
Michael: Something our listeners might want to consider, as well, we are usually here to help people learn how to do this. Whether you want to do it on your own or whether you are considering having it managed, one aspect of managed option selling, and excuse my little advertisement here, but it’s true that if you’re in a managed portfolio, such as this, you do get the advantage of economy of scale, where if you’re trying to sell 2-3 options on your own you could have them sitting out there all month and nobody ever looks at them. When you’re with an organization or a managed situation like this where you could be selling thousands at a time, those not only can get filled but often times at better fill prices than you’re going to get electronically. I know that’s something you have experienced first hand.
James: Michael, there is no question that we’re not market timers. We don’t know the exact time to get short soybeans, coffee, or get long some of the precious metals, but what we do want to have is just the best absolute liquidity available, the tightest bid-ask on these markets, and if that can change your entry by, say, 10%, which it often does, once again, it takes the need to be perfect timing entering these markets, which no one has, nor do we, but when you can get a fill 10% better getting in and then possibly getting out, that makes a world of difference.
Michael: All right. We’ve covered a lot of ground this month. I think we’ll hold up there for the month. We will be updating the coffee market and some of the other things we’ve talked about here over the next month and on our bi-monthly videos and also on our blog, so you’ll want to stay posted to that. If you are interested in learning more about managed accounts with OptionSellers.com, you can request our free Discovery Pack at OptionSellers.com/Discovery. As far as new account waiting lists, we are well into September right now as far as the waiting list goes for openings, so if you’re interested in taking one of those remaining openings for September you can contact Rosemary at the main number to schedule a perspective client interview. Those will be taking place during the month of August. You can reach her at 800-346-1949. If you’re calling from outside the United States, you can call 813-472-5760. James, thank you for a very insightful commentary this month.
James: As always, Michael, all 12 months of the year are interesting, but July and August certainly are one of our favorites.
Michael: Excellent. Everyone, thanks for listening and we will be back here with our podcast again in 30 days. Thank you.
James: Thank you very much.