Managing Volatility with Options

Last week we discussed the growing volatility in many of the best trending markets of the year. We noted that the uptick in volatility had to do with three primary sources. China’s attempt to cap inflation and put the breaks on their over heating economy, Irish bank solvency issues and the nervous anticipation surrounding Spain and Portugal and finally, money managers who were late to arrive are trying to capture year end performance and match their benchmarks. We can now add some certainty to last week’s assumptions. China did raise their rates. The European Union is actively striking a deal with Irish banks as well as taking an official look at Spain and Portugal and finally, money is flowing into stock index futures.

 

We can see through the Commitment of Traders data that commodity trader index funds are flowing into the stock index futures. This group has added approximately 50,000 contracts on last week’s minor correction and contributed greatly to the market’s ability to close virtually, unchanged for the week. Money managers will frequently use the added leverage of futures when chasing performance on the long side of the market or when hedging the risk of their portfolio when a downturn is expected. The fact that this buying pressure has been more than offset by commercial short selling only increases the uncertainty at these levels as the market’s largest players fight it out with ever growing conviction.

The same pattern is playing out in several sectors as these forces work their way through the markets. We’ve seen soybeans rally nearly 36% this year and silver was up 67%. The commodity market’s biggest winner for 2010 was cotton. Cotton was up more than 125% until news began leaking out of Asia that the textile industry was slowing down. These markets have all contracted considerably over the last two weeks as questions persist about the health of the global economic system and the stability of international trading relationships are re-examined.

 

Taking a look at any of these charts quickly makes clear two things. First, the trend is most definitely higher. Two, the pullbacks in these markets, when calculated on a dollar basis, are large enough to test even the strongest of commodity bulls. Commodity markets are leveraged instruments whose contract sizes were determined many, many years ago when prices were much lower. Consequently, the dollar value of the same percentage swings is much greater at these elevated prices. For example, a five percent swing in cotton at this time last year translated to a $1,671 swing in your account balance. Today, that same five percent swing is worth nearly $3,000.

 

The question that I’ve been asked most frequently over the last two weeks is, “How can I trim the dollar value risks of my commodity account while maintaining a comfortable diversification in case the stock market craps out in the face of a Euro Zone meltdown and a constricted China?”

 

My first response is that some commodities offer multiple contracts in various sizes. There are currently four listed contracts for gold. These range from the full size, 100-ounce contract down to a micro contract of 10 ounces. If this doesn’t work for your market of interest, I suggest using options to construct a hedge on an existing position or limit the risk when initiating a new one. Many people hear the word, “options” and their eyes glaze over as their memory drifts back to trigonometry and exponential curves. A better way to think of options involves using the insurance industry as an example.

 

Insurance is used to transfer risk. Buying the policy limits the potential of loss for a fixed cost up front. The seller of insurance collects a fixed fee up front while assuming the liability of the risk associated with the policy. This means that there are two ways trade options. Buying an option provides you with full protection for a flat fee. However, like most insurance policies, you may never have a covered incident to collect on. The premium you’ve paid in for the coverage you’ve selected will expire just like any other policy. The alternative is to be the seller of the option. You will collect the premium up front and if there is no collectible claim during the period, you keep the all of the premium when the contract expires.

 

I’d like to introduce one technical term for options trading and provide one example of how this all fits together. Insurance agents have actuaries. Actuaries are the number crunchers that provide them with the expected payout on any given policy. They’re the ones that make car insurance more expensive for a 16-year-old boy than for his 40-year-old mother. In options trading, the actuary is called, “delta.” Delta determines the probability that that option will be, “in the money,” at expiration. If an option is in the money, then it would be a collectible insurance incident. Delta is a probability and is bound by the 0% to 100% probability scale.

 

Given the large imbalance of positions in the stock market, options can be used based on the degree of protection one wishes to purchase. An option with a delta of 15 means that the market believes there is a 15% chance that the it will qualify as a covered incident on the policy issued. This option can be used to provide 15% protection to an existing position or, cut the contract size of the given market by 15%. Either way, the option can be combined with a futures position to limit the volatility of the account’s balance. Given the magnitude of the global issues being discussed and the elevated levels that many markets are still trading at, limiting the volatility of the account’s cash balance seems like a worthwhile endeavor.

 

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.

Diversification is not Immunization

Every market crash or bursting bubble is like the ice cream truck calling kids to the street. Portfolio managers and re-balancers know they get the opportunity to truly be heard only when something goes wrong.

Most people live their lives reacting to new stimulus. If something hurts, they don’t do it again. If something works, there’s no reason to change. Portfolio managers attempt to anticipate areas of pain and mitigate that pain wherever possible. However, there are times when efficient portfolio analysis, modern portfolio theory and just plain common-sense investing will still force one to endure periods of pain.

Portfolio composition is usually based on a collection of assets that tend to relate to each other in a predefined and expected way.

There are three basic relationships:

— Positive correlations: Two asset classes rise or fall together, predictably.

— Negative correlations: One class rises when the other falls and vice versa, predictably.

— Non-correlational: No predictable relationship.

The right balance of these relationships across multiple asset classes will smooth out returns and help to insure the predictable performance of one’s portfolio.

There’s an old saying from statistics 101: “Correlation does not equal causation.” We can measure how markets move relative to each other, but without understanding their relationships, we can’t say for certain what caused what. Sometimes, understanding “why” has a bigger impact on one’s portfolio than the actual mix of assets.

Last week we saw many markets fall. The stock market is lower, as are precious metals, bonds, grains, coffee, sugar, cocoa, crude oil and the energy markets. Many of the classic market relationships people use to balance their portfolios failed to behave in the anticipated manner and did not balance the risks associated with investing. Markets can and do, behave in unanticipated ways.

Commodity markets have been trending toward generally higher prices. The stock market has also had a nice rally and is up more than 9 percent since Labor Day. During this time, the Federal Reserve Board also announced a second round of quantitative easing to keep interest rates low and weaken the U.S. dollar. Consequently, bonds have rallied in price while the dollar has fallen.

The sudden about-face in many of the markets is twofold. First, the news regarding Ireland’s financial health has become increasingly pessimistic. Ireland was on the financial default radar, along with Greece, more than six months ago. Ireland has been very proactive in implementing domestic austerity measures to rein in spending. Furthermore, Ireland has also steadfastly maintained its financial issues are limited to a few banks that became overleveraged during their own housing bubble.

Unfortunately, the European Union has the same fears about Ireland and Greece we did in the U.S. with our own domestic banks and that is that every bank was more overextended than initially thought, requiring an even bigger lifeline to maintain solvency. Finally, Portugal and Spain are also on the verge of financial insolvency themselves.

The second fear to hit the markets was China’s announcement Wednesday its economy may be overheating again. Rumors are circulating China may follow several banks in Korea in raising its interest rates to slow down inflation and thus, economic growth. The data coming out of China certainly reinforces the idea it may constrict lending in the near future. China has a published cap on the amount of money its nationalized bank will lend in any calendar year and it is quickly approaching that ceiling.  The fears are also evident in China’s stock market, which has slid more than 5 percent in the last few sessions.

These two events combined to cause havoc in our domestic markets as they immediately unraveled the underpinnings of our market rallies. The Chinese news sucked the demand out of the commodity markets. China’s clampdown on inflation is pulling money out of the commodity markets and reducing overseas demand for raw materials. The news from Ireland and the European Union has the equity markets spooked. For many investors, the 50-percent correction in the equity markets from our own financial crisis is all too real and all too recent. Our domestic stock market’s rally and the quickly approaching year’s end makes it easy for many traders and investors to simply pull money out of the markets.

News events shock the markets and broadly sweeping economic forces create seismic shifts in market behavior. During these turbulent times, typical market relationships may fail to behave in the predicted manner.

As the Chinese economy becomes a first class consumer, we must accept our role as a supplier, rather than our historical position of end line consumer. As a supplier, we need to recognize the demand-needs of our trading partners. This is a broadly sweeping change that will affect the commodity markets for years to come.

News from Ireland and the European Union can shock the stock market, reawakening nightmares of 2008, but plans can be made to account for these events.

It does require proactive management of one’s portfolio. The old days of the passive hedge and allocation strategies may be gone.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.

Sugar Tops 2010 Commodity Market Volatility

It’s been a banner year for commodity markets as many of them have witnessed unparalleled growth. The one sided movement in many markets in 2010 has made commodity funds quite favorable as they are only able to invest through the purchase and ownership of their respective niche markets. However, long only commodity funds and Exchange Traded Funds miss out on one of the biggest advantages of trading commodities. That is, the ability to sell a market short and profit from an anticipated decline in prices.

Commodity contracts have set expiration dates. This makes them a very good short- term trading tool because speculators have to even up their positions prior to the contract’s expiration and we can track their actions through the commitment of traders reports. Only producers who intend to deliver their product and end line users of commodities stay in the markets until expiration. Some markets like  crude oil, trade all twelve calendar months. Other markets are delivered quarterly like foreign currencies and stock indexes. The sugar market also has four delivery dates per year. However, they’re not evenly spread out with the contract for March delivery becoming the actively traded contract in October.

The combination of being able to profit in a declining market as well as the uncertainty caused by sugar’s unique expiration cycle as well its relatively recent but substantial use in ethanol has made the sugar market, yes, the sugar market the single most volatile commodity market of 2010. In the commodity markets, volatility equals opportunity. In order to make money in any market, there has to be price movement. The fact that the commodity markets can be traded from both sides provides twice the opportunity. No market has illustrated that opportunity like the sugar market in 2010.

Sugar had rallied throughout 2009 on expectations of a small Indian crop due to a late and insufficient monsoon season hampering their output while Brazil’s was constrained by just the opposite problem. They had too much rain. Brazil’s overabundance of precipitation was hindering their harvest and slashing their yields. Brazil and India are the world’s top sugar producers respectively accounting for more than half of global production. These production concerns came with the pressures of growing a Chinese demand that has nearly doubled in the last ten years and outstripped its own domestic supply in 10 of the last 12 years.

Due to these pressures, 2010 saw the sugar market begin the year at levels not seen since the 1970’s. It’s important to note that sugar is basically a weed, like wheat. Its recuperative powers are stunning, given the right conditions. Therefore, the sugar market that found itself with tight supplies and a dwindling new crop came to experience some decent weather and a stunning recovery. In fact, the Brazilian crop that makes up nearly half of the world’s market and was perceived to be in such dire straits had actually recovered most of its anticipated yield.

The rapid recovery of the crop along with added acreage planted for the coming year quickly caused prices to plunge. The long only global commodity funds were forced to liquidate their positions on the way down. Their disclosure documents require them to maintain proper portfolio allocations, which causes them to buy more on the way up and sell on the way down. Their liquidation further depressed prices and the decline became a race to the bottom. Unlike long only funds, individual commodity traders as well as commodity trading advisors had the flexibility to participate and profit from the market’s decline. The price of sugar lost more than 60% between February and April of this year. This decline was fueled further by a Brazilian report that expected production to be 10% greater than the previous year.

The month of April saw the sugar market consolidate tightly in anticipation of the World Agriculture Supply and Demand Report. These reports are published monthly but the April report is an important one for the sugar market because it is the best reference of planted sugar for the coming crop year. The surprise in this report was a global uptick in demand to the tune of 5.3%. Considering the acreage came in as expected, the uptick in demand more than offset the added acres planted due to 09’s average sugar price. This was enough to reverse the course of the market.

Following May’s World Agriculture’s Supply and Demand Report, India stated that it was going to tax sugar exports to shore up its domestic supplies. Furthermore, the U.S. Dollar’s decline led to increased sugar purchases on the open market as foreign countries could now make purchases on the open market to satisfy the demand generated by their growing middle classes at a discount.

The effect of the falling dollar, a growing overseas middle class and tight global supplies have taken the sugar market from its final low of 11 ½ cents per pound up to a current price of over 33 cents per pound. All told, the sugar market started the year at generational highs around 28 cents per pound. The market then plummeted to a low of 11 ½ and has currently rallied to prices not seen in 30 years. As a comparison, gold would have to trade to $3,300 per ounce to match sugar’s high or the Dow Jones Industrial Average would have had to fall to 4172 to match the sugar market’s February to April decline. Trading of any type requires price fluctuation to make or, lose money. The ability to trade both sides of the market increases the number of opportunities. Volatility is the measure of price fluctuation and the sugar market is its poster child.

Trading the Coffee Market

Is the price of that morning cup of coffee doing more to wake you up than the coffee itself? Lost among the commodity headlines of gold, silver and oil prices, the price of coffee has risen to a thirteen year high over the last three months. Starbucks, Millstone, Caribou and others have all been forced to raise their prices to account for the increased price of their raw materials and the rise in prices has not been confined to high- end purveyors. Both J.M. Smuckers and Kraft Foods have been forced to raise prices on their Folgers and Maxwell House brands respectively.Currently, McDonalds is the only outlet able to hold their prices steady.

Coffee prices have risen 45% since the beginning of June due to serious production issues in multiple geographic locations. The extended length of the Asian monsoon season has affected the harvest of India, Vietnam and Thailand. These countries are responsible nearly 30% of global coffee production. While an extended rainy season has delayed the Asian crop, Brazil’s has been hampered by lack of rain. Brazil is the world’s largest producer and according to the Brazilian Coffee Council, the drought they’ve suffered through could cut production levels to the lowest output in four years.

The fact that retailers have been able to keep their prices reasonable, raising their prices around 11% on average is a testament to the necessity of the futures markets and their role in the economy. The futures markets were originally designed to allow producers and end line users of commodities to create binding contracts that specified the delivery date, price and quantity of the given commodity. Coffee retailers have been able to stay ahead of the rising prices by hedging their price risk in the coffee futures market. Contracts that were purchased prior to June have the benefit of the stable prices that coffee had been trading at for nearly two years.

Trading agricultural commodities entails an understanding of the price risk associated with each individual market. Broadly speaking supply and demand are the two types of risk that need to be accounted for. Agricultural commodities have a supply risk factor factored in to rising prices. This protects against any setbacks created during the growing season by the weather as well as accounting for any labor unrest during the harvest season. This is exactly the opposite of the risks associated with investing in the stock market. The fear is on the downside and there is a built in risk premium to the downside. The stock market deals with demand based risk.

Commercial traders are made up of two groups, the commodity producers who control the supply of a commodity and the end line consumers who create demand for the given commodity. These two groups are responsible for the battle to create value. When a market gets over valued, commodity producers come into the market and sell the crop they expect to produce within a given time frame. Conversely, when the price of a commodity falls below a perceived fair value, end line consumers like Kraft Foods and J.M. Smuckers will come into the market and stockpile the commodity to meet their future production needs.

This is the battle that’s currently unfolding in the coffee market. Coffee retailers are being forced to pay higher prices to ensure their raw materials for future production while coffee producers are taking advantage of the higher prices to make up for their lack of output. Tracking the movement of commercial trader positions through the commitment of traders report shows that end line consumers were large purchasers of coffee futures beginning at the end of June. We can also see that their buying appears to have peaked in early September. This cycle ensured delivery of the necessary raw materials through the end of the year.

Right now, the producers still have control of the market and we will continue to look for opportunities to buy selloffs in the coffee market. This allows us to put the purchasing power of major retailers behind us as well as the seasonal strength that tends to accompany the coffee market harvest period and into January. Our opinion will change when we begin to see the coffee producers rush to get their future crops sold. Whether the rush comes at higher prices or lower prices isn’t as relevant as the fact that farmers believe they won’t be able to sell their crops at these prices in the near future.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.