Per Bernanke’s statements this week and the never-ending push towards increased money supply, we believe the Fed is going to succeed in its goal of reflating the economy, but we could be wrong. Failure to reflate will mean the opposite: deflation and the potential for collapsing prices across the board. But what if there was a way to potentially capitalize on either scenario? One of the big advantages of slow markets is cheap options. Volatility is a large determinant of option pricing. The further volatility drops, the cheaper options get – all else being equal.
Cotton and sugar are typically hyper-volatile markets, but balanced fundamentals and trader disinterest have mired both in abnormally-tight trading ranges. The prices of both puts and calls have plummeted as option sellers have projected current, listless conditions into the future. Prices are now cheap enough that we can buy both puts and calls with the expectation that today’s atypical market conditions will not last and that new fundamental information or external factors – like a return to “risk on” or a worsening of today’s “risk off” scenario – will force prices out of their ranges.
Let’s begin with cotton...
Data Source: Reuters / Datastream
The chart above shows cotton’s abnormally-tight trading range. Bollinger Bands measure standard deviation and are generally two standard deviations from the market. Notice how tight they are compared to other periods. In fact, the last time cotton’s Bollinger Bands were this tight was in the summer of 2010, right before the market took off to the upside. Will the same thing happen again? Maybe not. However, history tells us that current market behavior is abnormal and that some kind of a breakout – either up or down – will eventually occur.
The trade below is designed to take advantage of a breakout of more than 20% in either direction prior to the expiration of the May options on April 12, 2013. Our upside objective is 95 cents in the May futures contract. Our downside objective is 55 cents.
Suggested Action – new trade: consider placing an order to buy May 85 cent cotton calls and May 65 cent cotton puts for a combined cost of 125 points ($625) looking for the white, fluffy stuff to break out of its extended trading range prior to option expiration on April 12, 2013.
If filled at 125, our maximum risk is $625 plus transaction cost. We can make as much as $4,375 should cotton reach either of our objectives. We may choose to exit sooner based on market conditions.
Data Source: Reuters / Datastream
The setup is similar in sugar. The trade below is designed to capitalize on a move of more than 9.3% in either direction prior to the expiration of May sugar options on April 15, 2013. Our upside target is 23.50 cents. Our downside target is 14 cents.
Suggested Action – new trade: consider placing an order to buy May 20.50-cent sugar calls and May 17.00-cent sugar puts for a combined cost of 62 points ($694.40) or less looking for sugar to break out of its extended trading range prior to option expiration on April 15, 2013.
If filled at 62, our maximum risk is $694.40 plus transaction cost. We can make as much as $2,665.50 should sugar reach either of our objectives. Like cotton, we may choose to exit the put, the call or both based on underlying market conditions.
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