From the March 01, 2010 issue of Futures Magazine • Subscribe!

Softs futures: Know your options

Futures contracts on cotton, orange juice, coffee, sugar and cocoa are included in a special group called “the softs.” Individually, the soft futures have characteristics such as price volatility and lack of correlation that make them interesting subjects for options pricing and analysis.

First, let’s look at the volatility profile of these markets. “Volatility equals opportunity” shows the price movements of the five March 2010 soft futures contracts over the four-month period from Sept. 1 through Dec. 31, 2009. The cumulative ratios of variations around a five-day moving average permit some of the minor price changes to be removed, while focusing on more significant movements.

On the cumulative ratios chart, it is clear that orange juice and sugar futures have the greatest volatility, with ratios that extend more than 10% above and below normal several times during the four-month span. Second in terms of price variability are cocoa and coffee, with cumulative ratios that occasionally exceed 5% more or less than 1. Cotton is the least variable of the five soft futures, generally staying within plus or minus 5% of 1.



Option prices are shown falling along smooth curves on “Volatility juices options premiums.” With each dot representing a strike price, the curves are computed based on 10 strike-price and futures-price pairs for each futures contract. The accuracy of the predictive price curves may be noted in the small variations of the option market prices from the price predicted by the least-squares regression equations.



This chart emphasizes the paired relationship between orange juice and sugar futures in terms of volatility and options pricing. For these futures, the options price curves are almost identical. They also are the highest of the five soft futures call price curves, reflecting the greater variations shown on the first chart. According to both charts, the market views orange juice and sugar futures as having the highest volatility among the sector. Coffee and cocoa form the second pair of matched options price curves.

This information can be vitally important to traders. Options prices that are closely associated may suggest spread trades when one or the other partner at a given strike price is temporarily over- or under-valued compared to the overall price curve.

WHEN VOLATILITIES RELATE
“Volatilities compared” lists call options prices as a percent of the strike price at the current futures price for the five March 2010 softs on Dec. 15, 2009, and Jan. 4, 2010.



On these two dates, orange juice and sugar have the highest volatilities as measured by the heights of their March 2010 call price curves. Next highest are cocoa and coffee, with cotton having the lowest expected volatility. Between Dec. 15 and Jan. 4, the options market apparently took note of the approaching March expiration date and made the soft futures options price curves significantly lower.

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