The grain complex -- wheat, corn, soybeans and oats -- is in some ways closely coordinated but at times widely different in the price movements of its futures contracts. “Cumulative percent price change” (below) shows how the futures performed from January through March 2012. Continuing their close correlation, wheat and corn played tag, with wheat being slightly more volatile. Meanwhile, soybeans increased at a relatively steady pace and oats slacked off in early March before catching up with soybeans by the end of the month.
Average percentage changes during the three months tend to support the notion that wheat and corn form a good pair for price spreads. Wheat declined on average 3.71% while corn dropped by an average of 3.99%. Oat and soybean futures increased on average 1.18% and 3.36%, respectively.
Overall, it is clear on the cumulative percent price change chart that soybean futures are the only one of the four grains to grow consistently during the first quarter of 2012, and that wheat and corn currently are in a trendless condition despite forecasts of higher food prices caused by low inventories. Only the substantial price gains for July wheat and corn futures on March 30 — 7.46% and 6.56% — give a hint of possible upward trends.
Volatility measures
On March 26, the options market placed July corn futures ahead of wheat, oats and soybeans in terms of predicted volatility. The curves on “Comparing July grains” (below) indicate the close fit among wheat, corn and oats, with the July soybean futures falling behind in the volatility forecast despite their faster growth trend over the past three months. As measured by the height of the call price curve as a percentage of the strike price where the futures price equals the strike price, the results are 6.68%, 6.41%, 6.02% and 4.30% for corn, wheat, oat and soybean July futures, respectively.
With 88 days to expiration of the July calls on March 26, the options market made predictions for the upper and lower price spreads during the remaining trading days. The spreads as a percentage of the strike price nearest the underlying futures price were 26.2%, 25.8%, 23.9%, and 17.4% for corn, wheat, oats and soybeans. The price spreads are between upper and lower futures prices at expiration that would result in neither a gain nor a loss from a delta trade on March 26, buying the number of calls indicated by the slope of the options price curve for each July futures contract sold short.
The spread implies futures price variations over the next 88 days of approximately 9% to 13%, up or down from the current futures price or about half of the predicted spread in either direction.
“Calls on wheat futures” (below) shows the May, July, September and December price curves for July wheat on March 28. Separations between options price curves on “Comparing July grains” are caused by differences in options market forecasts for grain futures volatilities at the same expiration date, while the curves on “Calls on wheat futures” are spaced apart because of changes in time to expiration and will shift up or down together depending on the market’s assessment of wheat futures volatility. (One way to think about wheat futures volatility is the chance there will be a futures price variation large enough to make purchasing a put or call option potentially profitable.)
On “Calls on wheat futures,” the curves for successively longer times to expiration have the following heights above the strike price: May, 3.95%; July, 6.33%; September, 7.91%; and December, 9.85%. It is typical for the price curves to be spaced closer together at longer times to expiration and to have larger spreads as expiration nears and accelerates the erosion of shorter-term time value premiums.
In “Building forex volatility strategies” (April 2012), it is suggested that variations of call or put prices from hypothetical or theoretically correct price curves could be the basis for spread trades between adjacent strike prices. Put and call options tend to be priced by variants of the Black-Scholes option pricing model, and this practice makes it easy to spot any option that is temporarily mispriced.
Exploiting anomalies
Call price curves on the July grains and wheat futures charts are formed by actual market prices, and those market prices fall close to a theoretically correct curve based on fundamental option pricing variables: Time to expiration, volatility of the underlying futures contract and the current futures price relative to the strike price.
An alternative method for constructing an options price curve is the LLP model available as an Excel spreadsheet that can be downloaded from our Tools & Resources page. The model uses market prices to compute a regression curve. Deviations of market prices from the regression curve generally are small in terms of option price points.
“Calls on July oats” (below) shows the accuracy with which the regression analysis matches the option market prices. The blue squares represent market prices for 14 strike prices and the black dots in the blue targets are prices predicted by regression analysis.
When variations in options points are multiplied by the number of dollars per point, the results indicate over- or under-pricing by the market for each strike price. Because options prices tend to regress toward the predicted or theoretical price curve, trading opportunities may occur.
Even when the predicted prices seem to be right on target, there may be substantial variations in terms of dollars. This was pointed out in “Building forex volatility strategies,” in which some currency option points are worth $100,000 or $125,000 while variations from the predicted curve are microscopic. For grain options, each option point is valued at only $50, but variations frequently are large enough to suggest trading situations.
Spread trades extending from morning to afternoon are possible by using the analysis shown in “July grains” (below), which includes price charts for July wheat, corn and soybeans. In each chart, the market prices and predicted prices are close to the theoretical price curve for large strike price (out-of-the-money) options. This is true for both a.m. and p.m. prices. However, when strike prices are smaller and the calls are near to or in-the-money, the variations are much larger in the morning and smaller — closer to the price curve — in the afternoon.
The ability to profit from this type of analysis depends on whether the morning and afternoon prices shown are actually available for trading. A suggested method is to compute the regression price curve based on listed prices early in the trading day and create spread trades with long options that are under-priced and short adjacent over-priced options. When plus and minus variations alternate through the list, some calls will be paired with more than one in the opposite direction. Spread trades in the area of smaller strike prices should be more profitable because of larger variations from the predicted curve.
It is tempting to think that variations could be picked out of an option price chain simply by drawing a line though the prices as they curve up with smaller strike prices; however, “Calls on July oats” shows why this may be an impossible goal. Computer analysis may be required to show magnified variations — even at the relatively small $50 per point given by grain options.
As always, the organization and pricing in the options market is impressive. Traders in general are able to trust relationships among pricing variables that have at least four decades of experience with an ever-expanding options market.
Paul Cretien is an investment analyst and financial case writer. His e-mail is PaulDCretien@aol.com.
