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Deep Out-Of-The-Money Options: A Calculated Risk
by Don DeBartolo
The trading strategy of purchasing a deep out-of-the-money call or put option has been referenced as purchasing a “lottery ticket”. Both present an opportunity for profits …
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Commodity Outlook
The Euro Zone Crisis Could Go On a Temporary Holiday.
It would appear that the Euro zone situation took a turn for the better on November 30th, as the EU made a move to expand the EFSF. But following that action, the markets weren't overly impressed with Europe's desire to gain the upper hand on the contagion threat, and it took other, outside developments to spark a real "risk-on" euphoria event. In addition to the feeble attempts to expand the EFSF from the EU summit, the markets also saw a reduction in the Chinese bank reserve requirement. There was also a coordinated move on the part of several central banks to provide increased assistance to the global economy, so it wasn't surprising to see sentiment improve markedly last week.
It is possible that the Euro zone crisis could go on a temporary holiday and that the very impressive start to the US holiday shopping season might allow the US to finish 2011 in a much better position than previously expected. Clearly, stalwart economic readings in the US contributed significantly to the market's capacity to tamp down Euro zone fears, and it wouldn't be misguided to think that strength in the US and Chinese economies could bring the world through the Euro crisis, especially after calls from the OECD last week that countries with "fiscal space" add stimulus. In other words, world leaders, central bankers and investors might have a much better environment that was expected from August through November.
Even the US debt situation might be spun into a positive, as automatic, across- the-board spending cuts will probably go further in reducing the deficit than "smoke and mirror" cuts that might have come from the Super Committee. There continues to be significant problems ahead for the US and Euro zone, as forced austerity should eventually restrain growth, but in the near term it is possible that the troubles will take a pre-holiday vacation and that the recent evidence of growth in the US will serve to carry optimism well into the month of December. On the other hand, the markets will have another hurdle to clear on December 9th, when EU holds its final meeting of the year, as the trade is expecting something concrete on the EFSF or a Euro bond instrument.
While the markets displayed a fairly impressive reaction to the events last week, one should not underestimate the potential size of the relief rally that could unfold in the weeks ahead. As can be seen in a chart of Consumer Confidence, there have been a number of events that have made investors and traders feel worse about conditions. In addition to the Fukushima disaster, the market was hammered by the Greek debacle, the US debt debacle and lately by the concerns over Italy and the Euro zone in general. Given the combination of an overdone negative sentiment, impressive US economic performance, blistering holiday sales and a global shift toward accommodation from most of the world's central banks, we expect "risk-on" to generally control prices into the third week of December.
Furthermore, many physical commodity markets look to approach the end of the year well below their 2011 highs, despite fundamentals that are in fairly good shape. The energy market is a prime example, as it could manage some noted gains in 2012 even under very meager forward movement in the global economy. Energy supplies managed to tighten in the 3rd and 4th quarter of this year during a seasonally slack time frame. And at times energy demand figures were strong, despite rampant fears of impending disaster in Europe and talk of a hard landing in China. In our opinion, many commodity markets simply need to skirt a return to recession to forge moderate gains into 2012. As can be seen from a chart of the Continuous Commodity Index, it could mount a 17% rally and still not be back to the 2011 highs.
Keep a pulse on the industry and access more commodity news.
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Markets to Watch
S & P Strategies
Despite a sharp rise last week and the fact that the March S&P might be set to carve out a 4 1/2 month high on the charts, we think that US stocks might have further upside potential in the coming weeks. We estimate that at the end of November, non-commercial and nonreportable traders (large and small speculators) were net long approximately 12,000 contracts, and we think that the market could be poised to add as many as 50,000 to that number. It wouldn't be surprising to see some back-and-fill action later this week, as the final EU summit meeting of the year on December 9th draws near, but the bull camp does seem to be back in the driver's seat, at least for awhile. Given the breadth of the recovery action last week in the Dow Jones Industrial Average (see chart), it is clear that recent optimism was even significant in the big cap or blue chip sector of the market, and that suggests the bulls may have staying power.
After months of very poor leadership from Washington, it is possible that there will be a successful bipartisan effort to extend the US payroll tax cut before the end of the year, and that could help extend or even exaggerate the relief rally in stocks and physical commodity markets. In order to transition the equity markets from a classic, technically-oriented, short covering/relief rally, it will probably require a more permanent backstop for the Euro zone debt problem, and it is possible that one could be in place by December 9th. However, in the event that equity prices "buy the rumor" of a final Euro zone solution over the coming week, we would suggest that longs bank profits and move to the sidelines or at least cover their positions by buying puts. In the meantime, initial upside targeting in the March S&P might be 1282.50, while a rise back to 1300.00 would probably require ideas that the Euro zone crisis is poised to take a back seat in the daily headlines.
Other developments that could give the bull camp added resolve would be a series of global easing moves and or news that the China has lowered it inflation fears and is set to take action to head off a slowdown. With the Chinese bank reserve rate reduction last week in what seemed to be a coordinated fashion with international central bank liquidity moves, it would seem like the world's bankers have gotten back onto the same page. The Euro zone crisis hasn't ended, and the US economy is still suspect, but in the short term traders will probably move to push stock prices higher to account for the noted reduction in global headwinds.
Those that think the Euro zone is set to once again disappoint the world in its December 9th summit might consider a ratio back spread in out-of-the-money March puts, especially if the market becomes massively, short-term overbought as a result of last week's events.
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Corn Strategies
The corn market looks to see volatile trade into early 2012, as the market could shift from being in a very tight stocks situation in 2011 to one where a surge in global feed grain and US corn sparks a sharp increase in available supply. May 2012 corn experienced a strong bull trend this past summer, rallying 98% from 400 on June 30 to 793 on August 30. Folllowing that peak, May corn set back to 595 by November 25th, as it priced in a more negative global economic outlook, as well as expectations for expanding feed grain production in South America in early 2012 and in the US next summer. If South America's weather is normal this growing season, the supply/demand fundamentals for the 2012/13 season could look bearish, and the market may see the need to reflect that in the first quarter of 2012.
The January 12th quarterly Grain Stocks and final Crop Production reports for 2011 may give traders a better indication as to whether prices have been high enough this season to ration supply and hold corn ending stocks above the pipeline minimum. If the final 2011 yield is adjusted down to 145 bushels/acre (due to the late harvest in Ohio and the tendency for small crops to get smaller as the USDA makes its revisions during the course of the year) and the USDA finds a need to adjust domestic feeding demand higher from the current estimate, which is a 22-year low, ending stocks could slip below 600 million bushels, and the stocks/usage ratio could fall below 5% to a record low. While this scenario is not likely, the tightness in the cash market in the weeks immediately following the harvest, the historically strong cash basis levels, and the extreme volatility for the previous quarterly stocks reports suggests that extreme tightness cannot be ruled out until after the January 12th reports are released. March corn has made a limit move on the January report date in each of the last five years.
The USDA Farm Service reported 9.6 million acres of prevented plantings due to flooding or other weather problems in 2011, which was up sharply from 6.9 million in 2009 and 4.2 million in 2008. This suggests that with normal spring weather, there will be plenty of incentives for producers to expand both corn and soybean acres in 2012. Also, an additional 1.6 million acres will move out of the Conservation Reserve Program for the coming year, which will add to the total acres available for grain production.
The record returns that corn producers garnered in 2011 will be all the more reason for them to expand acreage in 2012. We estimate that planted area could reach 94.4 million acres, an increase of up 2.5 million from 2011 and a new record. If we assume a return to a more normal yield of 164 bushels per acre and a 4% jump in consumption due to lower prices, we still end up with an ending stocks forecast for 2012/13 season of 1.983 billion bushels, up 135% from this season. This would also push the US stocks/usage ratio to an eight-year high of 15.1%, up from 6.7% this season and 8.6% last year.
At this point, we would look for March corn to remain in a downtrend, with 551 1/2 as the next target. The 631-642 level offers stiff resistance. Further support basis the nearby contract comes in at 544 1/2 and possibly 484 1/2.
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Soybean Oil Strategies
The general trend for soybeans for the first part of 2012 looks to be down, but the break into late November has left the market a bit oversold, and a bounce might be expected in the near term. With US soybean exports off to a slow start year and the crops in Brazil and Argentina looking good, it appears that the longer-term supply/demand fundamentals will stay in the bear camp into early next year. However, recent estimates from commercial traders in China have indicated that their import demand for the 2011/12 season may be closer to 60 million tonnes, rather than the 56.5 million that the USDA is currently estimating. Into late November the soybean complex was showing signs of being oversold, and January soybeans had already corrected 374 off of the late August peak. Any sign of adverse weather in South America could spark a dramatic recovery rally.
With tightening vegetable oil stocks, declining palm oil production, and an increase in bio-diesel demand in South America and the US, soybean oil stocks could tighten up quickly. Instead of approaching soybeans from the long side in December, traders might consider buying soybean oil instead. US soybean oil stocks are already down for five months in a row. If there is a weather issue in South America, soybean oil would probably offer a significant rally potential for early 2012. Palm oil production in Malaysia was already dropping off quickly in November from October due to excessive monsoon rains this season, and production is likely to continue to slip into February. The big discount of palm oil to soybean oil was an obstacle for a soybean rally over the past few months, but into late November, the discount narrowed to a 6-month low of just $28/tonne. This suggests demand for soybean oil could jump relative to palm oil.
US soybean oil ending stocks and the stocks/usage ratio are expected to drop to seven year lows for the 2011/12 season. Expanding bio-diesel usage in the US, Argentina and in other key producing countries is a possible underlying supportive force this coming season. US subsidies will halt at the end of 2011, so usage will be much more dependent on energy prices. Argentina may shift to a 10% bio-diesel mix from 7% at present, and both production and exports should reach a record high. A surge in Black Sea sunoil output helped to pressure vegetable oils into the fall of 2011. Russian oilseed production reached a record 12 million tonnes, up from 7.46 in 2010. However, by the end of 2011 much of the exportable oil from that region may already be booked.
Growth in palm production is expected to slow in 2012, as it will be difficult for palm trees to keep up the production pace from 2011. If so, demand for other vegetable oils is likely to increase. With a 3-year low in ending stocks, the palm oil stocks/usage ratio will be tight, so oilseed production from South America will be relatively more important for 2012.
Bearish outside market forces put pressure international vegoil prices recently, and fund traders have made a big push to short soybean oil in the US. Open interest climbed more than 37,000 contracts from November 15th to November 25th, during a period when January soybean oil prices fell from 52.90 to 48.35. This suggests that fund traders added to their hefty net short position during this period. For the week ending November 22, non-commercial traders were net short 20,512 contracts, an increase of 12,825 for the week. Non-commercial and nonreportable traders combined held a net short position of 27,247 contracts, up 18,160. Aggressive spec selling is a short term negative force, but many traders view soybean oil as oversold.
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Energy Spread
The premium of heating oil over gasoline has widened over the past few months, almost to the extreme levels it saw in 2008, but there are a number of factors that that could drive that spread back down in the weeks ahead.
There is a seasonal tendency for heating oil prices to rally ahead of the winter season as users build inventory, while gasoline prices have a tendency to slump as inventory levels are drawn down as the summer driving season ends. This year has been a special case for this relationship, partially due to unseasonably weak gasoline demand and firm global demand for distillates in general. This includes heating oil, but demand has been especially strong for jet fuel and diesel fuel. This dynamic fueled a surge in the spread relationship, with February heating oil prices trading nearly $0.62 above February gasoline, more than two and a half times its 10-year average.
At the start of the winter season, the EIA projected normal to below normal temperatures this winter for the Northeastern US. So far this fall, this has not been the case, with average heating degree days in October falling about 10% below the 10-year average. New York's Central Park experienced its fifth warmest November since 1869. The warmer than expected start to the 2011 winter season is a drag on heating-related demand and suggests that there could be a near-term pullback in heating oil prices.
Another factor that could reduce demand for distillates into the end of 2011 is rampant diesel production in China during the month of November. The major oil firms in China increased their refining capacity by 9% from October to help compensate for domestic shortages. That, coupled with a very active import schedule in November has left that nation flush with short term supply. This could leave them in a position to reduce their import activity in December and pressure the market.
Meanwhile, the gasoline market faces a bullish dynamic with the conclusion of the US ethanol subsidy at the end of the year. This could tighten gasoline supplies over the intermediate term. Ethanol's share of total gasoline consumption has been running is around 9.5% in recent weeks. While the exact impact of reduced ethanol production is difficult to gauge, any shortfall that would require additional draws from an already tight gasoline market sets the stage for higher prices.
We see the spread differential between February heating oil and February gasoline tightening in the coming weeks. This narrowing of the spread is expected to come as heating oil prices adjust to lower distillate demand out of China and reality of a warmer than expected 2011/12 winter. Gasoline prices should appreciate from current depressed levels as US inventories adjust to reduced ethanol production.
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Australian Dollar
After a month in which Euro zone risk concerns dominated the news, last week's central bank activity may have been a "game-changer" for the currency markets. China's move to lower bank reserve requirements and the concerted action by several central banks to lower Dollar swap rates had an immediate positive impact on macroeconomic sentiment and sent global equity markets soaring to the upside. While there are few expectations that Euro zone's debt problems will go away soon, global risk concerns have clearly been diminished. The US Dollar is likely to remain under pressure over the next few weeks as a "risk-on" mentality provides support for both equity and commodity markets. While the Australian Dollar has already made a sharp rally in the wake of last week's news, there is good reason to believe that it will continue gain over the near future.
Australia has avoided serious damage to its economy during the recent period of global economic turbulence, due in large part to Chinese demand for its natural resources. When China first gave signs of tightening its monetary policy, there was a negative effect on Australian markets that resulted in a rate cut by the Royal Bank of Australia early last month. With China's move last week to ease its monetary policy, that nation's demand for Australian iron ore and coal is expected to remain at fairly strong levels. By last week, Australia's sovereign debt ratings had achieved "triple-a" status from all 3 major credit rating agencies, which is in sharp contrast to how other major global economies have performed in recent months. While a rally to the mid-year highs may be a bit ambitious, the March Australian Dollar should remain well supported throughout the rest of this year and well into 2012.
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***This report includes information from sources believed to be reliable and accurate as of the date of this publication, but no independent verification has been made and we do not guarantee its accuracy or completeness. Opinions expressed are subject to change without notice. This report should not be construed as a request to engage in any transaction involving the purchase or sale of a futures contract and/or commodity option thereon. The risk of loss in trading futures contracts or commodity options can be substantial, and investors should carefully consider the inherent risks of such an investment in light of their financial condition. Any reproduction or retransmission of this report without the express written consent of The Hightower Report is strictly prohibited.
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| In This Issue |
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Never add to a losing position.
“Rome was not built in a day”, and no real movement of importance takes place in one day. A speculator should have enough excess margin in his account to provide staying power so he can participate in big moves.
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