- The CME's short-term options have been making headlines of late, and rightfully so given the explosion in trade volume during June.
- These options have proven to be a good hedge and or play during weather markets in ag production markets, as well as around government reports.
- The variety of reasons traders establish options again show us why it is misleading to focus on CFTC Commitments of Traders reports that include options positions.
This past weekend I saw a piece from Bloomberg talking about the explosive growth in short-dated options at the CME. Much of this has been due to “prices moving sharply depending on the weather”. According to the piece, “These products, which expire weekly or in different months than traditional contracts, accounted for a record 22% of all options transacted in June”. A bit later in the piece, one of the best option traders I know, Patrick Quaid, was quoted saying, “Options are the best way to hedge your exposure give the cost compared to futures during periods of high volatility like what we are seeing now”. There is much to unpack here, so let’s get started.
First, I have talked endlessly over the years about how agricultural production commodities are weather derivatives at heart. This past April I was interviewed by a long-time friend and global markets editor for MarketWatch Myra Saefong for her piece on orange juice, cocoa, and coffee. The bottom line among the analysts she interviewed, me included, was that each of these softs markets had been driven higher by adverse weather somewhere in the world. We can even make the argument cattle have recently been pushed to new all-time highs because of the drought across the US Southern Plains resulting in more cow slaughter, reducing the number of head down the road.
This past May, we saw Dec23 corn ((ZCZ23) and Nov23 soybeans (ZSX23) extend long-term downtrends on their respective continuous monthly charts, moves that have been in place since late spring and early summer of 2022. The week of May 15 saw Dec corn hit a low of $4.9075 (May 18) before closing at $4.9975. However, that day (May 18) saw the contract complete a bullish spike reversal on its daily chart, indicating the short-term trend had turned up. Why is this important? First, because the crop had been planted early so a hot, dry weather forecast for late May would have the same effect as what is normally seen during June. Additionally, both noncommercial and commercial traders were short the market at that point, and unless prompted to cover short futures and go long, the best hedge against a weather rally would be to buy short-term options.
Why? To begin with, historically weather rallies in corn and soybeans tend to last about 6 weeks. Being mid-May when the long-term downtrend was extended while the short-term trend turned up, those holding profitable short futures positions (and not wanting to cover) could buy short-term call options to “hedge exposure” as Mr. Quaid put it. With Dec corn, I talked about short-dated new-crop July call options that expired on June 23, five weeks down the road. Implied volatility had already started to climb (closing at 26.5% on May 18) and given volatility’s role as a multiplier on time value, with a 6-week timeframe in mind, the short-dated options made more sense. Dec23 rocketed to a high of $6.2975 on Wednesday, June 21, with implied volatility climbing to 32.5%. With daily stochastics now showing the market to be overbought, implied volatility elevated, and the 6-week weather market rally nearing its end those long call options were likely sold and new short call option positions established with out-of-the-money short-term August issues. That’s a lot of trade volume in a short period of time.
Nov23 soybeans have seen something similar, just a week delayed. Here the contract posted a short-term low on May 31, with implied volatility finishing the session at a low 20%. If we count six weeks from that mark the high would be expected this week. Given this, both noncommercial and commercial traders might’ve gone out and bought the short-dated new-crop August call options that expire on July 21. Still, this group had to be on their toes and look to sell this week, based on the calendar. As for volatility, it actually looks to have peaked last week 26% before sliding back to 22% this week. The other play that could’ve been going on in soybeans was traders buying the short-term July options at the end of May, then rolling them week to week to get through last Friday’s Acreage report. Again, all this activity would cause trade volume in options to skyrocket, all while traders continue to hold short futures positions based on other fundamental factors (weather, lack of demand, etc.).
This raises another point I’ve made over the years: True option traders position themselves for a number of reasons besides being bullish or bearish. As Mr. Quaid mentioned, options are a popular tool for hedging futures positions with the pros considering all the Greeks (Gamma, Theta, Vega, Rho, etc.), looking for a profitable opportunity. And though all the cool kids in the industry like to talk about the aggregate futures and options CFTC Commitments of Traders report, with options used for so many other reasons the best true measure of the bullishness or bearishness of the noncommercial side has been and will continue to be futures only.
I remember when the CME first released short-term options. I thought at the time it would grow to be a great tool for trading weather markets, seasonal volatility swings, riding through ridiculous government reports, and so on, and that’s what has happened. Once we get through the summer season activity in grain and oilseed short-term options will die down again, as investment money moves to the next set of weather derivatives, wherever it might be.
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