by Lee Lowell, Advisory Panelist
Saturday, August 1, 2009: Issue #1056

I’d like to focus today’s segment on the markets that typically see heightened activity during the summer months, due to the fact that it’s their prime growing season.

Specifically, that means the grains and orange juice markets.

As we’ve mentioned before, these products are heavily dependent on the weather for their yield. So if erratic weather patterns affect the crops’ growing cycles, it’s very likely that their prices will rise.

These products aren’t just consumables either. The farmers and food/drink companies that are front-and-center of their production use these markets for income production, too. They do this by using commodity futures and options contracts as hedging mechanisms.

So let’s hit the grains market first…

How To Play The Grain Market Upside With Commodity Futures

A few weeks ago, we keyed in on corn and wheat, stating: “Most of the speculators who play these markets are bullish in nature, so a majority of them are placing bullish bets, either in the form of outright long futures contracts or long call option contracts.

“Right now might be one of the best times to get into the grain markets on the long side because not only are we right smack in the middle of summer, but the prices of corn and wheat have just undergone a five-week massacre to the downside.”

Both commodities markets are still meandering around their lows, which offers another good opportunity to get in on a speculative bullish move. Here’s how to do it…

Take a look at the daily charts below for the corn and wheat December 2009 futures contracts.

If you believe in the seasonality of bullish moves for the grains, and are willing to take a speculative bet, now is a good time to consider a trade.

Your best bet is to hit the futures options contracts that trade on the floor of the Chicago Board Of Trade (CBOT). But make sure you do so in a way that gives you limited risk and unlimited reward possibilities.

For example, that could include entering a call option spread or just buying call options.

For call options, look to play the December 2009 or March 2010 options expirations, which will give enough time for any major weather scares to produce a good upside run.

• Corn: Specifically, consider December 2009 & March 2010 call options with strike price levels from $3.50 and higher.
• Wheat: Use the December 2009 and March 2010 call options that have strike prices between $5.60 and $5.80, or higher.

You can also trade these contracts through the Chicago Mercantile Exchange’s electronic platform, where you can bypass the brokers in the option pits. These contracts are exactly the same as the other, so you can trade them whichever way works best for you.

The Orange Juice Markets – A Hot Spot For Speculators

Having last broken down the orange juice market one month ago, this market has become a hot spot for speculators, as hurricane season got underway.

At the time, the market had carved out a low and we mentioned that it was shaping up for a “potentially lucrative seasonal trade.”

It certainly didn’t disappoint. Over a two-week period, orange juice futures launched higher to the tune of 2700 points. Usually, a move like that will take a good portion of the summer to develop, but with the oversold conditions that existed, it was stronger and quicker than normal.

This served all call option buyers well – especially those who took our advice to buy the January 2010 $85 cent call options. At the time, these options were available to buy for roughly 900 points or lower. And with the 2700-point surge, they tripled in price, fetching prices of over 3000 points.

So what now?

At this point, we wouldn’t advise buying these options anymore. The feverish move has already happened now and OJ prices are beginning to fall back. This is usually a one-time event every year, and unless orange juice drops back down into the low 80-cent area quickly (based on the January 2010 futures), we don’t recommend buying calls at this time. Markets move fast and timing is very crucial.

Let’s take a quick look at our other favorite “weather-prone” commodity – natural gas…

Commodity Futures – Waiting on a Natural Gas Bull

We’ve been bullish on natural gas for a while now, as it slinks along the lows it’s carved out since it reached manic highs last summer (along with many other commodities).

Natural gas will eventually hit a bottom, as it’s an in-demand natural resource that will be around for a long time. We just have to wait patiently for the turnaround, as the market grapples with high underground storage supplies.

Like with the orange juice market, though, we know hurricanes can cause huge upside moves, as the majority of drilling rigs are centered in the Gulf of Mexico. If a few storms go rumbling through that area, it could be the impetus that eventually brings this commodity out of the doldrums. But until then, we’ll bide our time.

One of the ways we’re playing this market in my Instant Money Trader (IMT) service is by selling out-of-the-money naked put option contracts on the natural gas exchange-traded fund – United States Natural Gas (NYSE: UNG).

This ETF tracks the movements of natural gas futures contracts, giving investors a lower cost way to enter this market.

And by selling put options, it allows us to collect the option premium, while having an opportunity to buy natural gas at unbelievably low historical levels. Check out this article for more information on how to sell put options.

That’s all for this time.

Good investing,

Lee Lowell

P.S. If you’d like to find out more about profitable option transactions, take a look at The Instant Money Trader.

By Lee Lowell, Advisory Panelist
Tuesday, October 4, 2005: Issue #247

Before becoming an options market-maker on the NYMEX, I never anticipated the initial pain that my legs would feel after having stood in the same spot for five and a half hours a day. That’s what pit traders do. They stand in the pit all day long, giving bids and offers to brokers in hopes of doing a trade with them.

As part of my series of articles on the life of a market maker, this piece will focus on the actual mechanics of what happens when an option order hits the pit, how to read fair value sheets and how the market maker plays a role in the action. Remember, everything that I explain in this article relates to my experiences as it happened on the NYMEX.

The First & Fastest Market Maker To Check The “Sheets”

The opening bell would ring at the NYMEX at 9:45 a.m. EST and close at 3:10 p.m. EST (pre-9/11). Within those five and a half hours, it was every market maker’s job to be the first – and the fastest – to give a specific broker a bid and ask quote that they needed for their customer.

Let’s say, for example, the upstairs Merrill Lynch desk (customer) needed a bid/ask market for the October 2005 Crude Oil $66 call option. The Merrill Lynch broker in the pit would randomly shout out to no one in particular, “How’s the Oct. $66 call?” That’s the market maker’s cue to check the corresponding futures market price and then check their “sheets” to see what a fair bid/ask market would be to yell back to the broker (and yes, everyone really is yelling at each other).

The reason for checking the corresponding crude oil futures market price is that if the market maker actually does an option trade with the option broker, the market maker will then immediately place an offsetting delta-hedge trade in the futures market to eliminate any immediate directional risk. Market makers are not there to pick a direction; they are there to capture a non-directional edge on the trade. I’ll explain that in a bit.

So, before actually giving the option broker his bid/ask market, you would see the 20-some market makers in the pit all waving to their “point man” in the futures pit for a quote on the futures market. The point man would hand-signal back to the options market maker approximately where the futures prices are trading (the options pit and the futures pit are two separate pits that sit side by side). Once the option market maker has a decent idea of the futures price level, he can then give the broker an accurate quote after checking his “sheets.”

How to Read “Fair Value” Sheets… And Keep Brokers On Your Side

The graphic below is a very simplified version of what an option market maker’s “fair value sheets” would look like. The one below contains the “fair value” and “delta” calculations for various futures and option prices for crude oil options as of October 3, 2005, with a fictional expiration date of October 21, 2005.

Here’s how it works: Along the left-hand side are prices for the front-month crude oil futures market in 5-cent increments. In this example, we’re only seeing prices for the futures at $65.45, $65.50, and $65.55. A typical trader’s sheet would contain many dollars worth of prices, so you would literally see market makers coming into the pit with thick booklets of trading sheets, sometimes for more than one commodity. You should see what the floor of the exchange looks like at the end of the day. Actually, you wouldn’t be able to see the floor because every inch ends up covered with obsolete trading sheets.

The “P/C” column indicates whether you are looking at a put or call, and the “VOL” column represents the volatility level you are using to help price the options. The top row of the sheets shows the strike prices that are available to trade in that particular commodity. Here we see strike prices for crude oil options ranging from $62 to $67. The last pieces of the puzzle are the “Fair” and “Delta” Columns. These represent the fair market value for each put or call at the corresponding futures price along the left-hand side, and the delta column lets the trader know how many futures contracts are needed to offset any option trade to balance out the directional risk.

The broker was asking for a market on the $66 calls and we find out that the futures are trading at $65.50 at that moment in time. We check our sheets on the left-hand side for the “calls” at the 65.50 mark with a volatility of 38%, and then we move along the top until we intersect with the 66 strike of the “Fair” column. We see that the fair market value of the $66 calls at a corresponding futures price of $65.50 comes out to be $1.828.

Any attentive market maker in the options pit would now yell back to the broker, “$1.80 bid at $1.85.” This means that the market makers are willing to buy that option at a price of $1.80, or sell it at $1.85. At this point, we don’t know if the broker is a buyer or seller, so we always have to give both sides of the market (we don’t care if we buy it or sell it).

Now, if the broker decides to buy the option from us at our price of $1.85, we have to tell him how many option contracts we want to sell. To make it simple, the delta sheets are based on a trade of 100 contracts. If we are lucky enough to sell 100 contracts to the broker, we look at our sheets again and see that the delta is .46. In order to offset our initial directional risk, we would hand signal back to our point man to buy us 46 futures contracts. Since we are selling call options to the broker, our initial delta is short 46 potential futures contracts, therefore we need to buy 46 futures contracts to keep our delta at zero.

The Paycheck’s in the “Edge”

Delta tells us a few different things:

• It tells us how much an option price will move for a corresponding $1 move in the underlying security; and
• How many shares or contracts of the underlying security must be bought or sold to offset any directional risk from an options position.

As I mentioned earlier, the option market maker is looking for an edge, not a directional trade. If that $66 call is valued at approximately $1.83, and we get to sell it at $1.85, then that’s what we call getting an edge. Our best-case scenario is that someone wants to sell that option now, and we would be able to buy it back for $1.80. That’s how market makers try to make their money. They continuously try to buy for less than what their sheets are telling them, and to sell it for more than what their sheets are telling them.

Unfortunately, it’s not as easy as that, but that’s the main thrust of the market maker’s job. The whole process of getting the futures quote, checking the sheets, doing the trade, and doing the hedge all happen in a matter of seconds. It sounds like a long process, but it’s not. The faster you are, the more trades you do. Speed is key!

So, do that everyday for five and a half hours without sitting down and/or not taking a break for lunch, and you, too, might be saying, “Man, my legs are tired.”

Good trading,

Lee

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