Excell with Options: 'Fly' Ag trades using options
Executive summary
With summer approaching, food prices increasing, and production decreasing, Agricultural markets may be in for a turbulent ride. In this issue, Rich explores opportunities in these markets:
- Lean Hog call calendar butterfly
- Corn call butterfly
You are probably sick of hearing someone talk about it by now. You know what I am talking about. No, it isn’t COVID (well, it kind of is). I am talking about inflation. I am old enough to remember when Jay Powell said inflation was transitory last year. Doh! This year, we are expecting growth to pull inflation lower. However, the fire the central banks are playing with is that inflation isn’t a number, it is a mindset. When you and I think prices are going to keep going higher, we are going to ask for a raise. If we can’t get a raise, then economists would tell you the substitution effects kick in, and we will delay current spending in favor of current saving with an eye toward future spending. The bulk of the discussion in the media and markets has been on the price of energy. Maybe this is all part of the climate debate. Who really knows? The move higher in energy matters. However, we are also seeing record food price levels in the global economy, as the data from the UN shows.
Figure 1: UN Food Prices
This is across all food we consider. However, just a couple weeks ago, we were given this market outlook from the USDA:
“Pork/Hogs: The Quarterly Hogs and Pigs report indicated reductions in almost all reported categories that determine 2022 production. Commercial pork production is reduced about 250 million pounds to 27.1 billion pounds, about 2 percent lower than production last year. Pork exports for 2022 are reduced to 6.595 billion pounds, 6.2 percent lower than a year ago, on weak demand from key importing regions.”
Source: USDA Economic Research Service Market Outlook 4/14/22
I thought the cure for high prices was high prices? When it comes to commodities like lean hogs, shouldn’t high prices attract more production and not less production? Maybe some of the substitution effect is creeping in, at least regarding exports.
Maybe there is a COVID reason. In a report issued in December 2021 on retail pork prices, “economists with Iowa State University, North Carolina State University, and the National Pork Producers Council found that pork prices, not industry profits, are rising. Prices are rising due to increased transportation costs, supply bottlenecks and delays, and increased labor costs throughout the pork chain. Those factors, said Iowa State's Dermot Hayes, NC State's Barry Goodwin, and NPPC's Holly Cook, were either caused or exacerbated by the COVID-19 pandemic. Other factors that have affected prices up and down the pork chain over the past 18 months, the report noted, include a 2.5% loss in pork packing capacity that resulted from a federal court order stopping faster harvesting line speeds, higher energy costs, rising feed costs and, most importantly, a shortage of workers, which has hindered productivity and caused wages to increase.”
Source: hogfarmer.com
So, it isn’t a recent phenomenon that there is an expectation of higher prices for hogs. The bottlenecks, higher labor costs, and increased fuel prices are still a factor. Now, we also have feed costs going up. It would seem futures market participants have been worried about this accumulation of factors for several months. In Figure 2, we can see from the skew in hogs for the last seven months that there has been a preference for upside strikes. The purple line is showing Skew for Lean Hogs going from -9 to +1 over the last six months. The Skew Index looks at Up Side skew (out-of-the money calls) minus Down Side skew (out-of-the money puts), so a more positive number shows strength to upside volatility.
Figure 2: CME Group Volatility Index (CVOL) skew for Lean Hogs
As I am not an expert in this product, I also want to see if there is some seasonality to prices for hogs. A quick view of the percent change in the front month futures for the last 10 years show there is some upside bias to prices in the spring followed by a downside bias to futures prices in the later summer.
Figure 3: Lean Hog futures price over 10 years
Now my interest is somewhat piqued. That starts to sound like a calendar spread could line up. There is some expectation of higher prices, but a lot of this news has been in the market for some time, even if the USDA suggests it might continue. A look at the term structure of volatility shows that implied volatility is certainly elevated for the July and August period relative to the months around it. That is also a period of peak futures prices if you look at the term structure of the futures.