Finding premium opportunities with commodities

April 25, 2016 12:00 PM

While equity markets have been plenty volatile in the first quarter of 2016, that comes on a long extended period of low volatility. And while volatility is seen as negative by many traders, without volatility there really is no market. This is doubly true of traders who short (write) option premiums. It is the volatility that allows premiums to rise so that hedgers or speculators can sell options. 

Selling options has become a more popular and mainstream strategy over the years. While it was once decried as picking up nickels in front of a steam roller, there is nothing wrong with that as long as you consistently avoid the steamroller. Which brings us back to our conversation on volatility. When volatility wanes, options writers have two options: Don’t trade or get closer to that steam roller. Many traders focused on equities only look at stock and stock index options. However, commodity futures are great markets to write options as seasonal tendencies often build up consistent premium. And you have many markets to choose from; if premium is too cheap on one, then pick another. 

For commodity option sellers, the latter part of 2015 presented some solid option writing opportunities. But with the exception of a few segments in the oil market, volatility was low across most sectors. Selling options in this environment can still produce firm results, but it involves a little more precision and a little more timing. It’s like tacking your sailboat against the wind. You can still get to your destination; it just takes a bit more effort. 

Enter 2016 and stock market mayhem. As we projected in November, this led to opportunities in various sectors. The initial beneficiaries were gold and silver. But that could all be changing in 2016 as option market volatility comes back to different commodity markets. 

As noted above, traditional investors view volatility as a bad thing. But for option sellers, it’s a really good thing. It means you’re taking premium with the wind at your back. You can collect higher premium while also maintaining a safer distance from strike prices. 

Option volatility can affect different segments of the commodity markets to varying degrees. Here is our take on the major commodity sectors, and an overview of what option sellers can expect in the coming months.

Metals: The February surge in gold prices had as much to do with fearful stock investors fleeing to safe haven assets as it did with the sudden plunge in the U.S. dollar. While the government keeps insisting that the U.S. economy is fine, private economists and investors are showing signs of concern. February U.S. consumer sentiment slipped to 90.7, compared with a January reading of 92.0. Personal consumption rose 2.2% in the fourth quarter, but was down from 3% in Q3 2015, indicating consumers are becoming more cautious. 

January housing starts were disappointing. All of this has economists speculating that the Fed will go easier on additional rate hikes in 2016. This spooked dollar bulls (at least initially) and combined with stock market worries, spiked gold prices (see “Golden VIX,” below). Gold calls with premiums of $500 to $600 were briefly available at the 2000 strike price last month—a great reason to always keep some powder dry in your account for when such opportunities arise. The fireworks in gold may have passed for the near term. However, volatility will remain in the options for both gold and silver for months to come—making these superior markets for premium collection in the first half of 2106.

Energy: We predicted OPEC taking action on production limits live on CNBC at the end of 2015. Chuckles were heard on the set. But no one is laughing today. In recent weeks, Saudi Arabia, Russia, Venezuala, Qatar and Kuwait all agreed, in principle, to freeze production — as long as other producers agreed to a freeze as well. By “other” they are referring to Iran and Iraq that have been opponents to such limits. Iraq has surged its production to a record 4.35 million barrels per day — the second most in OPEC as it furiously pumps for much needed revenue to fight Islamic State. Iran is eager to make up for lost time (and income) under sanctions, and has targeted an increase in exports of 500,000 barrels per day (above its levels during sanctions) by March 20. 

After several days of back door negotiating, Iraq agreed to go along. An agreement was reached between OPEC and Russia that excluded Iran. Holding oil near the $30 price level for this long has the Russians and Venezuelans screaming “uncle.” And while OPEC isn’t screaming yet, you can bet that their eyes are watering. Iran has left room for hope by indicating late last month that a cap could be a good idea. But don’t look for any major production cuts out of Iran anytime soon. The agreement was to freeze output at January levels. This will do little to dent the worldwide production glut in the near term. And it is not much skin off the nose of countries like Russia or Iraq that are already near top production capacity. What it should do is provide a psychological floor for oil prices. This, along with seasonal demand in the northern hemisphere in the spring, will be enough to get prices into the mid-$40s or higher by summertime. 

The problem is two-fold: OPEC has and always will cheat on production limits and a $10 to $15 per barrel rise in the price of oil will cause U.S. frackers—uninhibited by such production constraints—to ramp up output again. 

We still like selling distant puts in oil right now but the biggest opportunity will be in writing calls in May, June and July if oil is trading $10 to $15 higher than today’s levels (see “Safety zone,” below). Last month’s agreement could pave the way for an actual production cut this summer. But it will be awhile before any production cut begins to eat away at the global supply overhang. Look for the topics discussed above to make the energy sector the next in line to catch volatility.

Foods: Our January projection was for grain prices to stumble sideways to lower through Q1 as burdensome supplies remain the theme. Nothing about the last 60 days has changed that outlook. Brazil is at the beginning of what is expected to be a massive soybean harvest (about 15% complete through February), which will do nothing to help bean prices in the short term. It’s been a more than favorable growing year in Brazil, which means the coffee harvest also is expected to be a bumper—up to 51.9 million bags. This would be an all- time record for Brazilian output. There are exceptions here and one is cocoa, which appears to be building a base on the chart and is seeing some concern over the Ivory Coast Mid-Crop. Excess supply has nonetheless resulted in lower volatility for many of the grain and softs markets. 

But the U.S. corn and soybean planting season begins later this month. The El Niño weather pattern is expected to peak in March, but its influence on weather patterns in the United States will be felt well into summer. Grain markets also have some fascinating seasonal tendencies in the spring. While grain market volatility is low right now, that all could be changing in the next 60 days, making these enticing markets to watch for opportunities. 

While anytime is a good time to be an option seller, times of higher volatility can be the best. We could now be on the cusp of one of those periods. As an option seller, it might be time to think about raising your sail.

About the Author

James Cordier is the founder of www.OptionsSellers.com, an investment firm specializing in writing commodities options for high net-worth investors. He is the author of The Complete Guide to Option Selling 3rd Edition (McGraw-Hill 2014).