Using options, you can develop a risk management strategy. I am going to look a specific strategy that involves selling a covered call that can be used in the July corn futures market with a medium/long-term timeframe.
Having the proper risk management strategy in place is the absolute key to being a successful trader. The most basic form of risk management, that nearly all traders are familiar with, is the stop-loss order. However, a stop-loss order is not always the most appropriate risk management tool.
The trouble with just using stops as a risk management tool is that you may need to place a stop at a very distant price in volatile markets. This is because it is easy to get stopped out of volatile markets if your stops are too close. Every trader wants to avoid the situation where the markets stops them out and then proceeds in the direction originally anticipated. But placing wider stops results in risking more capital before taking your loss.
Corn – Fundamentals
If you watched the news you probably have heard about rising food prices and the potential for shortages throughout the world. We’ve heard about the high demand for ethanol as crude oil has hit record highs. Meanwhile, corn has also hit all-time highs. July corn futures closed at $6.04 ¾ a bushel on Tuesday, April 29.
Who would have figured that we would be trading near $6 a bushel for corn? A prediction of $6 corn would have seemed ridiculous two years ago, when the market traded near $2 a bushel. But here we are.
So what has been driving this market? The recent strength in corn is being driven by weather. At this point in the year, many farmers are trying to get the crop in the ground. It’s very important to get corn planted in a timely fashion because it requires a long growing season. If there are delays, farmers may ultimately not be able to plant as much corn, and may opt instead for another crop, such as soybeans.
On Monday, April 28, the USDA’s crop progress report (issued weekly during the growing season) showed that farmers are planting about 8 percent less corn than last year. So going into the growing season, the market is already seeing less acreage. The April 20 crop progress report indicated that farmers have planted about 4 percent of their corn so far. The April 28 report indicated that farmers have now planted 10 percent of their corn. The crop progress report is based on 18 states that planted 91 percent of last year’s U.S. corn acreage.
Traders were expecting more. Last year at this time, the farmers had already planted nearly double the amount of corn at 20 percent. To give you more perspective, the 10-year average, for the amount of corn planted at this time of the year is 29 percent. The current crop progress, at 10 percent planted, is definitely behind the schedule. A longer winter this year in the U.S. has definitely made its mark. The expectation of more rain in this cooler weather is also causing a lot of problems that are helping delay how quickly farmers can get their corn in the ground.
Strategy – Selling Covered Calls
If you are bullish on corn, why not just buy futures? First of all, corn is currently a very volatile market. You can see on the chart above that in the last 30 days the market has been as low as $5.20 and as high as $6.28. That’s a pretty large range for a short period of time.
If you were to just buy corn futures outright, one way to manage your risk would be to place a stop-loss order at a specific price point. But you need to be a little savvier than that. You need a bullish strategy that will provide a better safety net if you’re wrong.
I’m going to outline an options strategy in the corn market that I’ve been recommending for my clients. This strategy, in my opinion, is a much better form of risk management than just placing a stop.
For demonstration purposes I will use rounded numbers. Please keep in mind that since prices are always changing, these numbers need to be adjusted based on current conditions. You are more than welcome to call me at 800-798-7671 if you would like updated prices on this strategy.
The strategy involves buying July corn futures at $6.01, selling a July 610 corn call and buying a June 570 corn put.
From here we need to examine several things: breakeven points, risk, and margin requirements. This is a medium term play on the corn market in which you would plan to hold for at least 30 days.
Trade Details
Let’s look at the details of this trade. You are long corn futures at $6.01, and you achieve downside protection with the options. With this strategy, you would have brought in approximately 38 cents in premium from the July 610 call and paid out 13 cents to buy a June 570 corn put, while being long the futures contract at $6.01.
Now, why would we want the June versus July put? Simple, the June put is like a hedge in case things get really bad in corn. We’ll end up paying less for the June contract than the July contract because the June position expires earlier, on May 23.
The first benefit of this trade is the substantial reduction in margin requirements. The margin on corn futures is $1,350, but not with this trade. This trade gets run through span margin. This means that the exchange recognizes the risk management principle behind this trade. In late April, the span margin for this trade was $327 with maintenance margin of $242. This is substantially less margin than $1,350, which would be required if a trader wanted to just go long one futures contract.
Risk & Reward
Here’s how to figure out our maximum reward on this bullish position. Remember, you are long the futures at $6.01. You sold the 610 call, which would be considered a covered call. From $6.01 to $6.10, you can make 9 cents.
You also received a premium of 38 cents from selling the 610 call. Of that 38 cent premium, 13 cents is paid toward the 570 put. This leaves you with 25 cents in premium. Add this to the 9 cents in potential upside profit that you can make and you get 34 cents. Every penny is corn is equal to $50 per contract. Thus, your maximum profit potential is $1,700 (34 x 50 = 1,700), excluding commissions.
The corn market would have to be at $6.10 or higher at call option expiration (June 20) for that maximum profit to be realized. Not bad, considering that the span margin required at the time was only around $327.
You can figure out your breakeven point by subtracting your net premium (25 cents) from the price you bought the futures ($6.01). In this example, your breakeven would be $5.76, excluding commissions. And since you are long the 570 put, you have 6 cents worth of risk, or $300.
This trade allows you to sustain some of the market volatility. Obviously, you want corn prices to go up, but this position gives you some protection should they go lower. If prices go lower in the near term, the puts increase in value and the calls and future position decreases in value. This allows you to stay in the market for a rebound that we would expect should the market go down.
Michael Sabo is a Senior Market Strategist with Lind Plus. He can be reached at 800-798-7671 or via email at msabo@lind-waldock.com.
Past performance is not necessarily indicative of future trading results. Trading advice is based on information taken from trade and statistical services and other sources which Lind-Waldock believes are reliable. We do not guarantee that such information is accurate or complete and it should not be relied upon as such. Trading advice reflects our good faith judgment at a specific time and is subject to change without notice. There is no guarantee that the advice we give will result in profitable trades. All trading decisions will be made by the account holder.
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