There are certain noises almost guaranteed to catch any human being’s attention: like the ch-ch-ch-ch-ch of coins (or corn kernels) tumbling on top of each other into a rich pile, or the alternating ooo-Ooo-ooo-Ooo of an ambulance siren or the rising boop-dee-dee-boop tones on a combine harvester’s grain tank alarm.
Or, a slot machine.
Comparing farming to gambling is a tired cliche, but these last two weeks of November feel more like a roll of the dice for soybean prices than almost any timeframe I can remember. Usually, in an agricultural market, the chances for a major price change depend on the weather, somewhere. Drought in South America, monsoons in Asia, frost in the United States. Now, with harvest almost complete in North America and emergence going well in South America, the global soybean market has few weather worries. Rather, it’s waiting on something even more fickle: human politics.
The typical trading pattern of selling U.S. soybeans to China has been severely disrupted by a trade war between those two largest economies. The market has been worrying about all this since spring, and in recent months, physical reality has justified that worry. Monthly exports of U.S. soybeans to China have fallen 98% since the start of 2018. Shipments to certain other countries have improved, but not enough to relieve the unusually full storage facilities at this time of year. Soybean basis bids continue to run anywhere from 15 cents to 55 cents weaker than they would normally be in an uninterrupted trade environment.
Anyway, that’s all old news. The gamble now rests on a meeting between the presidents of the two countries on the sidelines of the G-20 summit in Buenos Aires on Nov. 30. Will the rhetoric from their meeting be cold and combative, as it was from Vice President Pence last week at the Asia-Pacific economic summit? If so, that may imply to soybean traders that the 25% Chinese tariff on U.S. soybeans is likely to remain in place for some time. Alternatively, what if the two presidents will meet with a friendly attitude that signals potential negotiations in the near future? In that event, U.S. soybean futures prices could jump higher rather suddenly. We can calculate the odds of any dice roll in a craps game, but we can’t even begin to calculate the odds of all this human politics, human emotion and human behavior, which the soybean market will have to parse at the end of this month.
We can, however, see that traders are expecting something to happen, in one direction or another. Forward-looking volatility calculations (the implied volatility of options contracts) have been surging through the month of November so far, while backward-looking volatility measurements (e.g. the 21-day historical standard deviation of actual futures prices, annualized) have been falling. Ever since landing at $8.82 on the Nov. 1 market close, the January soybean futures contract hasn’t budged more than 2.1% up or down from that level. Basically, it’s been standing silent at the table, waiting for the dice to roll.
Typically, the implied volatility of options and the actual volatility of the underlying futures contract tend to move in more or less the same direction. When an underlying asset’s price starts to swing wildly, the expectations for future wild price swings also increase. This relationship doesn’t always hold true, of course — especially not when traders express a directional bias in their demand for certain options contracts.
For instance, while the actual historical 21-day volatility (annualized) of the January soybean futures contract has fallen since last month and is currently at 15.37%, the implied volatilities of at-the-money January soybean puts and calls have risen during that same timeframe. A January soybean put at an $8.80 strike price currently costs 16.7 cents, while a January soybean call at the same $8.80 strike price currently costs 22.4 cents (note the disparity). The option contract has an implied volatility of 18.32%, according to the Black Scholes model. Its implied volatility is up about 3 percentage points since the start of this month, which may not sound like a lot, but it’s notably a move in the opposite direction, compared to the less-volatile underlying futures contract. These volatility percentages can all be thought of as measuring a theoretical 1-standard-deviation move of the underlying asset price within one year. Roughly speaking, an implied volatility of 18.32% suggests the options market believes there’s only a 32% chance the underlying soybean price will be higher than $10.41 or lower than $7.19 (up or down one standard deviation) within the next 251 trading sessions. Higher volatility numbers suggest better chances of bigger movements, either up or down.
The same pattern of increasing implied volatility can be noted in March soybean puts and calls, expiring Feb. 22, as well as in the January ones, and both for in-the-money and out-of-the money option contracts. Implied volatility has also been increasing during the month of November for soybean puts and calls with more distant expiration dates, even as far out as next November, although the lighter trading volumes for those contracts make it difficult to attach much meaning to those results. It’s sufficient to simply draw the conclusion that options traders are expecting soybean prices to shift more in upcoming months than they have during the past few weeks.
Now market participants, including farmers, only need to decide how much exposure they want to that potential shift. And that’s where that tired old cliche of farming-equals-gambling suddenly becomes useful. Under the psychological influence of flashing lights and cheerfully beeping machines, a gambler chooses how much to wager, then receives a loss or a payoff from that bet. He chooses to put more or less of his capital at risk, in the same way a farmer might choose to expand or contract her operation. Before the wager, however, the gambler must choose which game to play, in the same way a farmer might choose a marketing strategy. Before that, the gamble must choose which casino to enter, in the same way a farmer might choose which crops to plant. And before all of that, the gambler and the farmer made their first choice: whether or not to gamble at all.
Elaine Kub is the author of “Mastering the Grain Markets: How Profits Are Really Made” and can be reached at email@example.com or on Twitter @elainekub.
Source: Elaine Kub, DTN
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