Sharp Reduction in Corn Stocks Halts Downtrend, But Sets Up Market for Option Strangles

James Cordier submits:As I watched stocks collapse to new 2010 lows last week, I was amused to observe all of the TV “analysts” from daytime fund managers to nighttime TV stars talk about which stocks are at good “value” levels now and where you should be buying. Buy low and sell high. It all seems so 1990’s in today’s investment environment. Buy low and sell high only works if asset values are moving up. If they are not, it typically isn’t going to matter what asset you buy. When is the mainstream media going to start talking about other ways to make money in the financial markets?As an option seller, you know better. You prefer to sell something and get a premium for it – any time. You prefer not to have to pick (or care much about) outright market direction. Anybody short S&P calls this week knows what I mean. That being said, you might want to consider selling premium in a market whose price is based on more reliable supply demand fundamentals than on something as chaotic as the S&P 500. Investors seeking such a market may want to consider the current situation in Corn. Supply Adjustment Stops Bears MomentumAgricultural commodities tend to have a cyclical type of price movement based on their planting and harvest cycles. Uncertainty and anxiety at planting time tends to build a “risk premium” into prices during this time frame. Once the crop is in the ground and growing season gets started, traders tend to relax a bit and the risk premium tends to come out of prices to some extent (unless there are serious weather problems.) Prices tend to ebb and flow during growing season based on weather reports, crop conditions and projected yields. Prices can sometimes lose site of the big picture during growing season and focus too much on weather or crop conditions instead of overall projected supply. It is often not until harvest or in the months immediately after harvest that the “true” price of the commodity is reflected. June was a month in which corn found traders squarely focused on it’s growing season. Weather conditions are nearly ideal in the US Midwest. As of the June 27 Crop conditions report, 73% of the crop was rated in good to excellent condition. This is a full 5 percentage points above the 20 year average of 68% for this far along in the crop year. The latest USDA estimate has the US producing 13.370 billion bushels of corn this year (260 million more than last year) and has 2011 ending stocks projected at 1.573 billion bushels (30 million bushels less than last year due mainly to increased demand for ethanol). For a complete discussion of ending stocks and how important they are to price, be sure to read “Hefty Soybean Crop makes Call Selling Good Bet” June 14, 2010 available in the Option Seller Newsletter Archives free at www.OptionSellers.com. With 2011 ending stocks projected so close to 2010 numbers, the corn market had no real reason to move substantially higher in price. In fact, with this season’s crop planted early and off to a great start, many felt the yield for the 2010 crop (amount of corn produced per plant) would increase the size of the crop from the USDA’s June estimate. This has put much pressure on Corn prices through June. But on June 30th’s quarterly stocks report, the USDA changed the game. Stockpiles Fall Faster Than ExpectedThe USDA report showed US corn stocks as of June 1 were 4.31 billion bushels – well below analysts estimates of 4.613 billion bushels. In addition, the government reduced it’s 2010 estimate for US planted acreage to 87.872 million acres. Average analysts estimates were for 89.302 million acres. To those not familiar with the corn market or investing in corn, these numbers are significant and they caught the trade off guard. Corn prices rallied sharply because fewer beginning stocks and fewer acres mean less corn in the bins when harvest is over in the fall. How much less remains the question. However, don’t expect corn prices to run away. While the acreage number represents a significant revision, it is still up 2% over last year. In addition, crop conditions remain favorable as we head into the critical “pollination” period for corn in July. Most in the trade are now assuming a higher yield per plant than in the last USDA report which should partially make up for the reduced acreage.It is our opinion that traders simply got a little “too bearish” on the corn crop and let the excellent crop condition pressure prices too far to the downside. The quarterly stocks report was a wakeup call to the bears – but probably not the start of a raging bull market. The market is now expecting a reduction to ending stocks numbers in July’s USDA Supply/Demand report and it is pricing that reduction into the market now. While this should support prices, a successful pollination means the crop is literally “made.” Much anxiety tends to come out of prices at that point. This should temper any substantial upside action in corn. We see prices gravitating back up towards the 3.90 to $4.10 level with a .25 cent “window of fluctuation” on either side of that range. That may mean nothing to futures traders or buyers of assets. However, to option sellers, it means everything. If that estimate turns out to be the case, selling puts and/or calls outside those ranges can be an excellent way to collect income without picking market direction or trying to guess tomorrow’s weather (which way too many people try to do). Selling puts and calls in the same market is called a strangle. We feel the corn market is now fundamentally set up for such as strategy – especially after this past week’s influx of volatility resulting from the report. This is an investment that can be “legged” into (selling calls on up days and puts on down days) to maximize the premium collected. As an option seller, you can look to implement this strategy in July while the “regular” investors are trying to pick the low in the stock market. We will be working closely with our managed accounts in the timing of this premium collection opportunity.Disclosure: No stock positionsComplete Story »