In our analysis of corn and soybean markets from May and June, we highlighted a burdensome supply picture. However, for both markets, we suggested summer weather rallies might offer opportunities for selling inflated call premium.
If you’ve been waiting for one of those, you now have it. In the first half of July, soybean prices rallied roughly 13% while corn prices jumped more than 10%.
But not where you might think. A ridge over the Dakotas has brought a spell of hot, dry weather to crops grown there. And while you may not think of North and South Dakota as soybean country, more than 14% of the U.S. crop is grown there.
Does that mean that the U.S. corn or soybean crop is in danger of a substantial loss? Probably not.
The irony of this summer’s weather is that while Dakota crops are certainly stressed, crops in core growing regions of the Corn Belt in Illinois, Indiana and Ohio are experiencing near ideal conditions. However, that has not stopped the weather bulls from blowing their annual trumpets.
The Fundamental Facts
Yes, there is a weather issue in the Northern Plains. As of mid-July, 72.8% of North Dakota and 72.4% of South Dakota are in a drought. Wheat, soybeans and corn have all rallied as a result (see “Summer scare,” below).
Here, we focus on soybeans. Corn will likely be the least affected of the three because less of it is grown in the Dakotas, and wheat is a different animal altogether because it has more of an international aspect.
The fear is this: Although only 14% of the U.S. soybean crop is grown in the Dakotas, even a slight drop in yield could have a noticeable impact on ending stocks. For instance, the U.S. Department of Agriculture’s projected average yield for the 2017 soybean crop is 48 bushels per acre. If that drops only by two bushels per acre, soybean ending stocks could drop by nearly 40% of current projected levels. Worthy of consideration? Of course. But it will take one heck of a crop setback in the Dakotas to have a two-bushel per acre impact on the entire crop – especially with a virtual greenhouse effect occurring in the central and eastern growing regions.
The market could be starting to realize that soybean prices were sharply off their highs in the second half of July. This is largely the result of a moderating near-term weather outlook and a ho-hum USDA supply demand report on July 12.
The USDA projected U.S. soybean ending stocks for the 2017/18 crop at 460 million bushels – slightly lower than the average estimate of 485 million bushels, but still at their highest levels since 2006/07 (see “Big crop,” below). This is largely the result of crisp demand.
More importantly, the USDA raised global ending stocks to 93.53 million tons, up from 92.22 million tons last month. This is largely the result of higher production out of South America. The key is this: While it’s true that the USDA estimate does not yet reflect any yield loss to the 2017/18 crop, the market is likely already in the process of pricing it in.
Worlds don’t end because the crop gets a bit of yield shaved off. What happens is that prices will adjust higher to reflect the slightly lower supply. The problem with weather markets is that nobody knows how much lower that supply will be, and thus, they just buy, buy, buy – often blindly.
The result is that weather markets will often price in a worst-case scenario – producing a surge in both prices and volatility – only to come tumbling down later when the damage turns out less than the worst-case scenario. Thus, trying to time or short-term trade weather markets is futile and not recommended.
But for option sellers, these can be the best of times. Surges in volatility can make the ridiculous strikes discussed in past articles, available to traders.
It is common for retail traders to get whipped into a frenzy and bet on a worst-case scenario. The option seller can take a position to profit from anything less – and in some cases – even if a worst-case scenario occurs.
Too Late to Sell Bean Calls?
Traders used to trading the underlying futures contract may feel they need to time the market right, to pick the top so to speak, to make money on a price retreat. This is not necessarily so when selling options. Thus, even when a market has crested and prices are in decline, a call seller can still make money. This is especially true in the case of weather markets.
Why? Because the volatility created by the weather rally can remain in the option long after the rally is over. In soybeans, this is often true even after the critical podding season has ended and the crop has, in essence, been made. Thus, although the primary risk of crop damaging weather is over, the option market is not yet reflecting this. These can be excellent times for selling options.
While the short-term weather forecast is moderating, longer-term Dakota weather models remain unclear. We are not here to predict the weather; nor should you. What is clear is that to get a two-acre per bushel reduction in total U.S. yield, it will take a nearly 50% loss of the Dakota soybean crop. This would put 2017/18 U.S. ending stocks somewhere between 240-290 million bushels. This appears to be the worst-case scenario the market was pricing in in July. While that would almost certainly require a price adjustment higher, it would still be the second largest ending stocks in 10 years.
As discussed earlier, worst case scenarios are by definition unlikely. If weather moderates ahead of soybean podding in August, soybean prices will likely adjust lower. Another spate of hot weather could give prices another jolt.
We would view such rallies as opportunities to sell over inflated call premium to weather speculators unfamiliar with the core fundamentals. The early July weather rally was such an opportunity in both soybeans and corn. Keep alert for another one in the coming weeks.
Traders should consider the March Soybean 13.00 call on rallies and even the 14.00 call should prices break above July highs. Weather rallies are tough on short-term traders. But they can bring the gravy for fundamentally informed option sellers. Use the public excitement to the benefit of your bottom line.
This concept is true for most commodity markets that have measurable seasonal tendencies. While we have been talking about grains in general and soybeans in particular, other commodity markets provide opportunities from periods of seasonal related volatility. Coffee, for example, often provides opportunities from spikes in volatility due to the threat of frost, which occurs in our summer months as coffee is mainly grown in the Southern Hemisphere. In most years the residual inflated premiums persist past the point where there is a legitimate risk of a frost induced spike.
In trading options, and trading in general, the key is to find an edge. In a sense all trading is value trading and successful option writers attempt to find value in premium. A common cliché of option writing is that the option writer is picking up nickels in front of a steamroller. While we could dispute this characterization, the point for the trader is to find trades where that steamroller is further down the road and that premium levels have risen to the point that they are able to pick up quarters.