From the November 01, 2011 issue of Futures Magazine • Subscribe!

Grain & cattle spreads: Finding an edge

Option alternatives

In addition to futures price changes, put and call options may be used in pair spreads. "December calls" (below) shows corn, wheat, live cattle and lean hog calls on Aug. 23, 2011.

Wheat and corn option price curves are related closely, while live cattle and lean hog curves are lower. Options for the two meat futures are priced lower because of the market’s forecast of smaller price spreads before expiration day – in other words, lower volatility. As shown by the chart, the option premiums as a percent of strike price range from more than 7.5% for corn and wheat, to 6% for lean hogs and 4% for live cattle.

Two of the forces at work on the call price curves are:

  1. The daily erosion of time to expiration continues to reduce the premiums of puts and calls until eventually the premium will disappear and the option will be priced at either zero for out-of-the-money options, or intrinsic value (the underlying futures price less the strike price) for in-the-money options, and
  2. Volatility differences perceived by the market, causing low-volatility options to fall more rapidly as time passes — an advantage held by options having larger estimated price spreads at expiration.

"Soybeans and corn" (below) illustrates the edge provided by higher volatility, with the March corn option curve at a height of over 8% compared to the height of March soybean calls at approximately 6%. Unless the market changes its opinion of comparative price volatilities, this means that over time soybean calls will lose value faster than corn calls. As the pair moves closer to expiration, this valuation difference should be taken into account in trading soybean-corn option pairs. Because the volatility advantage is option-centered, its effect on the CME Group’s synthetic soybean-corn price ratio futures is indirect — indicating the options market’s forecast of price changes in the futures contracts.

On "December calls" (above) wheat and corn option price curves are approximately the same height where the underlying equals the strike price. In fact, "December calls" shows that wheat and corn curves are almost identical. Thus, there is no volatility advantage to either of the futures, and decisions on trading spreads for this pair depend on variations in percent changes of price or price ratios.

The option price curve showing the least expected volatility and, thus, the most vulnerable to the loss of premium because of time erosion is that for December live cattle. With approximately 90 days to expiration, the calls are subject to the effect of time — a small amount of time premium is expected to be lost each day. According to their relative positions on the price curve chart, corn calls should have an advantage over live cattle in terms of time decay.

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