“What goes up must come down.” Isaac Newton’s quote in reference to gravity should not also be applied to futures and commodity options. That mentality has the potential to be both costly and risky. After a market becomes parabolic on news or events, unfounded or not, it may not necessarily retrace to prior price levels. Or at least retrace even in the expected timeframe. There may be actual underlying fundamental or technical reasons for such a move that comes to light in the after math. However, if you can identify low cost and low risk opportunities you may be able to take advantage of a potential retracement. Look no further than the recent hurricane season.
During the 2017 “hurricane season” two destructive hurricanes struck the south and southeastern areas of the United States. The first, Hurricane Harvey was classified as a Category 4 (Category 5 being the highest such level) at the time of reaching landfall in Texas on August 25. By the time Harvey reached Louisiana on August 29, it weakened before all together dissipating on September 3. A week later Hurricane Irma, which was also classified as a Category 4, reached Florida on September 10. Irma was downgraded to a Category 3 by the time it made second landfall, and further weakened to a Category 2 later that day. By September 12 Irma weakened to Depression status over the Georgia-Alabama border. Both hurricanes caused varying destruction to anything in their paths.
The “Cotton belt” stretching from northern Florida to North Carolina and westward to California was in the path of both hurricanes. The Cotton harvest season begins in July in the southern part of Texas through late November to the north. While Cotton requires a long growing season with plenty of sunshine and water, it requires dry weather for harvest. The futures contract was range bound as harvest began (the 50-day Moving Average was approximately 70.00 cents). According to USDA estimates the U.S. increased its 2017 planted acreage while the global demand remained steady to slightly weaker. This underlying fundamental kept pressure on the futures contract. However, when the paths of the hurricanes were forecasted to reach Texas and Georgia, the Cotton futures became parabolic. Based on 2016 data the top two states in Cotton production were Texas and Georgia with a combined 9,686 (in 1,000 bales). The remaining eight states total was 4,891 (in 1,000 bales).
In the first trading session following Hurricane Harvey’s landfall the October 2017 Cotton futures market opened at 68.61 cents and would trade no lower, closing at 70.33 cents on the session. A 1.72 cent move or $860 per contract higher. Over the subsequent trading sessions before Hurricane Irma reached landfall the Cotton futures market was up a total 7.54 cents or $3,770 per contract. The futures market was reacting to the possibility of destruction to the crop in its most important production areas.
Were the forecasted paths not to come to fruition or the severity of the crop damage to be less than expected, the probability was that the futures price would retrace to pre-hurricane levels. Recall the USDA estimated the U.S. increased its 2017 planted acreage while the global demand remained steady to slightly weaker. The forecasted path of Hurricane Irma seemed to change daily. It was unclear if the crop in Georgia would be affected at all. On September 7th, three days before the hurricane was set to make landfall in Florida the October 2017 Cotton futures market was trading above 75.00 cents with a high at 75.79 (9/06/17).
I identified an opportunity. On Thursday, September 07, I recommended purchasing the October 2017 Cotton 72.00 put. Option expiration took place the following Friday on September 15. Having less time value meant the premium price provided a low cost opportunity opposed to the more expensive December options. After the weekend it would have been known if the crop was affected or not anyway. Volatility was higher making it necessary to overpay theoretical value slightly to establish a position, yet the premium price was reasonable and a low cost. The 72.00 put option was purchased for 29 points or $145. The entire risk on the position was the premium paid plus any commission and fees. The 72.00 price level was near the 50% Fibonacci Retracement of the hurricane rally. There were also gaps on the chart during the rally that would be filled on a potential sell-off. The downside target was the pre-hurricane price level at 68.61 cents, the low on August 28.
Option contracts may be difficult to liquidate at a desired price when trading short-dated options (expiration was in nine days) and with a volatile underlying market. Well aware I fully intended to use the right to the underlying futures contract if necessary. As noted above by the time Hurricane Irma reached second landfall in Florida it was downgraded to a Category 2. By the time it reached Georgia it was further downgraded to a Depression. The crop appeared to out of harm’s way as desired. On Monday, September 11, the October 2017 futures contract opened at 75.57 and would sell-off to a low of 69.02 within three trading sessions. That was a 6.55 cent or $3,275 move lower. With two days until option expiration and holding an in-the-money option, I purchased the underlying futures contract at a price of 69.99. By going long futures the profit was locked in without having to trade in a thin options market. At a futures closing price below 72.00 cents on expiration day the result is exercised into a short futures position.
72.00 cents minus 69.99 cents equals a gain of 2.01 cents or $1,005 ($500 per cent).
On an option exercise the premium price is forfeited. The net result of the trade was a profit of $860 ($1,005 – $145), not including the commission and fees.
If at a closing price above 72.00 on expiration day the result is a 72.00 put worth zero for a loss of the premium paid or $145. However there would be a profit on the futures position long from 69.99 to the marked-to-market closing price. To avoid the margin required and risk associated with a futures contract the option was immediately exercised when the futures contract order was filled. So indeed the final profit on the trade was $860 per contract, not including the commission and fees.
What went up was the Cotton futures price. It did so on news. What came down was the Cotton futures price. It did so on underlying fundamentals. A low cost and low risk opportunity became a profitable trade. I continue to watch for additional opportunities such as these. To follow along contact me directly at 1.800.993.9656.
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