World Futures & Options Report
Today’s themes –U.S. Dollar, S&P 500 index, Japanese Yen, Soybeans & Corn, U.S. equity options movers – Lehman Bros. (LEH)
U.S. dollar
This week’s resilient performance by the greenback reminds of us of the prisoner played by Paul Newman in the 1967 movie, Cool Hand Luke. Newman played an ex-soldier who had seemingly lost his way in life, ending up in prison. Clearly wayward and without purpose, Newman provoked inmate ringleader George Kennedy into a boxing match to defend his leadership. From the get-go it’s clear that the burly Kennedy would win the fight, and for the first few minutes inmates and prison guards cheer the fight. Newman refuses to give up and the scene decays into a staggering prisoner refusing the pleas of inmates and Kennedy alike to stay down.
This week we have witnessed a strong turn of fate for the wayward dollar. Two key factors at play are the collapse of the commodity market and the shift of emphasis away from the plight of the domestic banking system, with the spotlight glaring firmly at European banks. Here the dollar gets a reprieve thanks to more incredible write downs related to the U.S. mortgage market and an appeal for capital from Europe’s uber-bank, UBS. Witness too the demise of its chief as the parallel to the American market runs deep.
With the outpouring of grief as far as the foreign banking sector goes, the euro currency is coming under a lot more strain. We noted two weeks ago how rumors surrounding Britain’s largest mortgage lender, HBOS, were weighing on the pound sterling. Now the UBS and Deutsche Bank stories are serving to weaken the euro, especially as the former appeals for $15 billion in further capital to shore it up. Make no mistake - these banks are not going anywhere, which is possibly why the equity market has kicked the new quarter off in high spirits. The train tunnel that the financial market had become is slowly staring to show glimmers of light at its end.
We offer a view here this week that the turning point for the U.S. dollar may have sprung from from an unusual source. Last weekend and hot on everybody’s lips this week, Barron’s ran as its lead story the view that speculators in the commodity market had laden the port side of the commodity cruise ship to such an extent that the vessel was in danger of tipping over!
Not only have speculators swollen the coffers of investment funds that go long those markets, but even more have dived into the red-hot futures market for commodities. If you can grow it, dig it out of the ground, suck it up through a rig or run a truck or even city on it, you can bet it’s in hot demand and will be packaged up neatly as a futures contract. Commodity pools have become the next best thing and the next generation of investment gurus are all pontificating about just how great they are and just how rich it’s going to make them!
As Barron’s points out, if these investors would just for a day do precisely what the commercial growers and miners do with these products for about a day, the cruise liner would right itself. Everyone except the smart money is long of commodity products and Barron’s coherently points out the next asset bubble in commodities is set to burst. That point has neatly helped the exhausted dollar pick itself off the floor once more as burnt out speculative money finds its way out of crude oil and soybeans and back into a rallying dollar.
The Dow Jones commodity index has quickly unwound the last 15% of its run up since early February.
S&P 500 index
The stock market is not necessarily taking its cue from a rise in the dollar, but is certainly reacting to perhaps the final-flush for financial companies. The announcement this week by Treasury Secretary Paulson of a far-reaching overhaul of the entire financial system may do a lot to heal the wounds inflicted over the last six months. On the table right now we have quite a selection. Not only do investors have the potential for sweeping regulatory reform, but they also have an implicit guarantee that banking failure is not an option. The rescue of Bear Stearns and the failure of short-sellers and put buyers to defeat the resolute management at Lehman Brothers make for a positive market environment. While earnings won’t come back for several quarters, the size of the nine-tenths of the iceberg below the waterline is becoming less uncertain all the time.
Chart: InteractiveBrokers
Looking at the chart above immediately sends up two red flags. First, we have to question whether the St. Patrick’s Day spike to the downside really was the last leg of the bear market. Second, look at the relative strength index below the chart, which indicates an extremely healthy (if you’re bullish) divergent picture. RSI is used to measure price action relative to its recent range. In that sense the index is often used to confirm or refute the validity of secondary moves. Measuring the value of the index at the January and March low points clearly depicts rising values for RSI as the bottom develops and could therefore be said to create “negative divergence” of prices. In other words the technical health of the market could be reasonably strong and some the bigger picture downdraft may well be over.
Japanese yen
With the recovery in equities comes a dilemma for currency traders as far as “carry-trades” are concerned. As long as the dollar had remained under pressure and as long as stocks were depressed, it made sense for traders to either unwind the short yen/long dollar trade, whether that was Australian dollar or Brazilian real as the long currency. So long as it was high yielding, investors could ride on the coattails of rallying asset markets and use super-cheap funding in the yen or Swiss francs. The loss of appetite for risk fuelled advances in the low-yielding currencies and served up a boon to option traders as we noted last week. The April 100 straddle in the Japanese yen continues to erode as implied options volatility declines.
The chart of the yen above shows the impulse reaction to the revival in the fortunes of the global equity bourses. Stocks gained and immediately rekindled the prospects for both risk appetite and carry trades. As such the yen was unceremoniously dumped out of bed this week. Note the declining value for option implied volatility in the chart above.
Soybeans and corn
As noted earlier, Barron’s Magazine threw cold water on the commodity fire over the weekend. And it couldn’t have been timed better from the perspective of market impact heading into the key USDA planting intentions report to start the trading week. We noted one analyst report earlier that day that investors were clearly bulled up for the report and that failure to deliver on crop predictions could serve to unseat more riders than the Kentucky Derby.
One of the most painful falls for jockeys was to be found in the soybean complex – see chart above. Beans had proven to be extremely friendly to speculators who were getting used to using the age-old expression of “beans in the teens,” which hadn’t been used for many a year. For many speculators the wild ride in soybeans was an easy slam dunk trade. The rising demand for agricultural products had led to high priced corn. Corn was grown at the expense of soybeans last year thanks to sizeable profits from the corn crop. Beans were therefore in short supply at a time of rising global demand. So it made sense to position for more bullish moves out of beans.
However, two things happened. First, many farmers thought along the same lines as did most. There must be value in planting more beans this year because their price is rising hard. But second, we’ve noted here before the expensive cost of adding corn-specific fertilizers to the ground. Farmers who hadn’t locked in the high cost of such fertilizers for the new crop have had to think twice about just how much they can make this year given the rise in seed and fertilizer costs. Finally, we mustn’t forget that land needs to be rested such that it doesn’t become exhausted. The impact of corn crops, thanks to the nitrogenous fertilizer, is to tire the soil quicker than with other crops.
The outcome in the latest planting intentions report this week was that 18% more acreage was given over to soybeans compared to last season. That was a total surprise to bean traders who were caught high and dry with few willing buyers left in the market. As you can see from the chart, prices fell for several sessions as longs liquidated and short speculators tightened the thumbscrews on the market, driving prices further down. Having peaked at close to $16 per bushel last month, the May future has slipped as low as $11.21 this week.
There was more fun in the corn complex as traders speculated that what was bad for beans was bullish for corn. Corn traded at a record high in the May contract at $5.88 per bushel as traders anticipated supply constraints on corn.
In terms of implied options volatility on corn options, thing are getting quite pricey. A popular haven for bullish corn option trades has been the May contract at the 580 strike call. Even when corn prices were easing back last week an investors was still adding to an arsenal of long call positions. Open interest this week grew to some 18,000 contracts, up around 28% on one week ago. Now that we are already into April, this trade has about three more weeks to run. The current premium stands at around 25 cents on the contract, implying that the trade would come good at $6.05 per bushel.
With underlying May corn futures trading close to a high at $5.83 we should examine the degree of implied volatility built into the current options price. With such implied volatility running at around 38% the premium looks steep especially with such a short time period to expiration. Halving the value for volatility has a commensurate impact on the call option price, which means that with the USDA report now having lifted at least some uncertainty out of the way, the market could push implied volatility lower. Anyone who’s buying corn options could do with understanding the extrinsic value that they are currently paying for.
U.S. equity options movers – Lehman Brothers (LEH)
With the financial sector inspiring Tuesday’s glittering ‘Fool’s Day rally as one might imagine, there was a sharp move lower in implied volatility across the board. It was as if a giant sigh of relief had escaped across Wall Street, which afforded a near 400-point rally in the Dow industrials average. Some of the day’s big winners were banking stocks. In our daily options commentary we noted the skewed put buying that had taken place last week by many speculators on shares of Lehman Brothers as vultures gathered in the hope that an “abandon ship” wholesale liquidation might occur.
It did, but was short lived. As the uncertainty surrounding the stock rose, so did the implied volatility on quoted options on the investment bank. Two weeks ago at the height of the Bear Stearns speculation shares in Lehman took a swan dive from almost $35 to within a quarter of a dollar of $20. At the time, option market-makers elevated the price of volatility to 220% at the depths of the panic. Subsequently options have traded with no less than 83% volatility implied.
Last week it appeared to us that one brave trader seemed to have the gumption to call it “game over” for short-sellers at Lehman. Around the same time, a senior executive within the company allegedly stated to employees that he believed short-sellers had sunk Bear Stearns and were eyeing the same end for his own company. Clearly that message wasn’t lost on this trader who took full advantage by selling elevated premium readings in the at-the-money straddle eight months forward in the January contract. The trade was executed at around a gross premium or credit to the seller of around $21.00. The investor might not expect a move in the share price at Lehman, but is anticipating survival for the company. Without going into detail about several minor points such as the fact that Lehman has a vastly different and far-wider ranging business model than Bear Stearns, nor to mention its cash-rich position. Suffice it to say, Lehman’s management played a shrewd hand by issuing $4 billion convertible shares. This was quickly perceived as being the final straw for anyone short of the stock. By bolstering its already healthy liquid or near-liquid stance management has nailed down the lid of any talk about heading for bankruptcy.
By selling the 40 call and 40 put in January this trader is predicting that the share price for Lehman’s will remain within a range prior to expiration of $19 to $59. At the time of making the trade, that covers the downside price spike while it would also imply a 50% rally to the upside for shares towards year end. A logical analyst might raise the question as to why investors would send shares to that level given what’s happened since August with the depletion of capital at many of the most famous Wall Street investment bank names.
Looking at the order tickets above in the table, you can see how the current price of the straddle has decayed in the last few days. The current volatility reading at around 65% implies a fair price for the same straddle at a 13% discount to last week’s entry price. But as you can see in the second order ticket, if we adjust the entry based upon a volatility order at around 32% the same straddle price works out to be $10 or roughly 50% of the entry price. Nice work for selling into a mania!
Andrew Wilkinson and Rebecca Engmann Darst
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