Updates of Options Strategy on Wheat Futures
ZW1!On June 15th, I issued an options trading strategy on CBOT Wheat Futures.
At the time, I expected wheat price to experience a very large move but was unsure of its direction. Consequently, I recommended a Long Strangle options strategy: Purchase both an out-of-money (OTM) call and an OTM put on September Wheat Futures. The original trading idea may be found here: https://www.tradingview.com/chart/ZW1!/YtyfCg3f-In-Search-of-an-Edge-for-Non-Professional-Traders/ .
Let’s review how this trade performed five weeks after its initiation:
Initial market conditions on June 14th:
• September Wheat Futures (ZWU2) is quoted at 10.54/bushel.
• An OTM call with a $12.00 strike price is quoted at 17 cents.
• An OTM put with a $9.00 strike is quoted at 4.625 cents.
A Long Strangle will cost $1,081.25, as each call and put contract is based on 5,000 bushels of Chicago wheat. This is the maximum amount you could lose if wheat price did not break out the upper ceiling or fall through the lower floor set by the strikes.
At this writing on July 18th:
a) ZWU2 futures is quoted at 7.81/bushel, down $2.73 or -26%. Our expectation of big price move is proven to be correct.
b) Call options with $12.00 strike price is quoted at 10 cents, down 7 cents. Even though futures price declines, there is still time value in the OTC call options.
c) Put options with $9.00 strike is quoted at 85.5 cents, up 1749%. Due to the nonlinear nature of options pricing, our put is hugely profitable as it is now $1.19 deep in-the-money.
What can we do today? There are two options:
1) Sell both the call and put with offsetting trades. The call would realize a loss of $350, and the put has a profit of $4,043.75, making the combined total at $3,693.75. Taking the $1,081.25 premium we paid upfront as our cost base, gross profit will be $2,612.5 per contract, or +242% return in a five-week holding period.
2) Hold the positions. There are five more weeks left before the August 26th options expiration, and wheat price could make bigger move. For illustration purpose, let’s use today’s price as exercise price. The Call would expire worthless as it is out-of-the-money, and we lose the $850 initial investment. However, by exercising the put, we gain $1.19 (=9.00-7.81) per bushel, and $5,950 per contract. The combined gross profit will be $4,018.75, or +372%.
Why does this trade work? The key lies with a properly set-up strategy. It’s time to revisit our Three-Factor Commodity Pricing Model:
Commodities Futures Price = Intrinsic Value + Market Sentiment + Crisis Premium
In February through May, the Russia-Ukraine conflict put a huge Crisis Premium on wheat price, driving it from $8 to $12-$13, before moving lower to around $10.
Since June, surging inflation, aggressive rate hikes, and recession fears overtake supply concerns as the main market driver. As fighting in Ukraine drags on, the impact from crisis diminishes, and Bearish Market Sentiment takes over. Commodities markets from energy, metals to agricultural products all suffered a huge loss.
Looking forward, I expect that Intrinsic Value, or traditional supply and demand factors, would come back as key market mover. The recently released World Agricultural Supply and Demand Estimates report (WASDE) from the U.S. Department of Agriculture set a bearish tone in the grain market, sending wheat price to fall further.
For our CBOT Wheat Strangle options trade, I favor closing the positions now over holding it to expiration. Here is my reasoning:
In a classic economic supply and demand chart, fundamental factors move market price along the supply line and demand line. Price movement tends to be moderate and within a narrow band. This is what the Wheat price chart shows before February 24th.
On the contrary, crisis premium pushes either the supply line or the demand line to shift sideway, resulting in big price jumps. In the case of Wheat futures, investors are concerned that a loss of Russian wheat would reduce global supply by as much as 25%. Wheat price responded by a series of limit-up days and jumped 40% in two weeks. Note that daily price limit (up or down) on wheat futures is 70 cents per bushel.
In the absence of conflict escalation in Ukraine, volatility in wheat price would likely stay muted going forward. Additionally, time value, which is part of the options premium, will decrease quickly as contract expiration nears.
In the Black-Scholes Model, options price is positively correlated with volatility. Expected low volatility combined with diminishing time value will make it difficult for our Long Options to increase in value. This is my argument against holding on to the options.
As the likelihood of global recession grows, food crisis will stay on as a major global issue in 2022 and 2023. Famine could hit weaker economies. Agricultural commodities will be a good risk management tool to hedge the rising food cost.
Happy Trading.
Disclaimers
*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.
Jim W. Huang, CFA
jimwenhuang@gmail.com
jimwenhuang@gmail.com
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