In Search of an Edge for Non-Professional Traders

16 ביוני 2022

ZW1!
What do Gold, Crude Oil, Natural Gas, Corn, Soybeans, and Wheat have in common?

Their prices all go up in a global crisis. In other words, these strategically important commodities are positively correlated with the level of risk. “Risk Up, Price Up; and Risk Down, Price Down”.

Everyday non-professional traders (NonProfs) usually have a disadvantage trading these futures contracts. Let’s see who we are up against:
• Commercial Firms, including producers, processors, merchants, and major users of the underlying commodities.
• Financial Institutions, such as investment banks, hedge funds, asset managers, proprietary trading firms, commodity trading advisors and futures commission merchants.

These professional traders (Profs) have industry knowledge, market information, research capabilities, trading technologies, high-speed and seemingly unlimited amount of money. They contribute to about 80% of trading volume for a typical futures contract.

So, what could you do in an uphill battle? Recall our Three-Factor Commodity Pricing Model(https://www.tradingview.com/chart/GC1!/GstAaeyu-Event-Driven-Strategy-Focusing-on-Global-Crisis/):
Commodities Futures Price = Intrinsic Value + Market Sentiment + Global Crisis Premium

In peaceful times, the coefficient of Crisis Premium is zero. The Profs win out easily. When a global crisis breaks out, price pattern may be altered completely. The chart illustrates how CBOT Wheat Futures behaves before and after the start of Russia-Ukraine conflict.

Based on Efficient Market Hypothesis (EMH), a baseline futures price reflects all information regarding the Intrinsic Value and Market Sentiment factors. However, the Crisis Premium is unknown to all of us. The Profs could not use fundamental analysis or technical analysis to gain a better understanding of Mr. Putin’s mindset. Few had inside information of the inner working of the Kremlin or the Russian generals, either. Your guesses are just as good as the Profs when it comes to what’s happening next.

An analogue: In a close-range hand combat, the Profs have no use for their arsenal of missiles, fighter jets and tanks. NonPros with limited resources are on an equal footing to trade against the Profs. It’s critical to pick a fight that you have a chance to win.

Recall that we discussed how to define global crisis with binary outcomes, and select financial instruments based on their responses to those outcomes. (https://www.tradingview.com/chart/ZS1!/SV1wmHjv-Event-Driven-Strategy-on-Binary-Outcomes/) For CBOT Wheat Futures, Ukraine conflict has become the dominant price driver since February 14th. But after four months, we still have no clue when or how the war could end.

Let’s define it in two simple outcomes: War and Peace.
The first one includes all scenarios that the war would continue or intensify, where the second one could be a peace deal or a victory in favor of either Russia of Ukraine. As a NonProf, you don’t want to dive deep into the impossible task of forecasting the different scenarios. Keep it simple: War = Risk Up, Peace = Risk Down.

The probability of either outcome is real. It’s difficult to predict which one is more likely. Therefore, directional trades of Long or Short are both risky.

Many event shocks exist to make the wheat price fluctuate. If a major wheat producing country announces an export ban, wheat price could fly because of global market shortage. However, a phone call between Mr. Putin and Mr. Zelenskyy could punch wheat price to the ground.

Russia is the No. 1 wheat exporter. An end of the conflict could end the sanctions against Russia and increase global supply by 44 million tons of wheat. Looking back in 2018 and 2019, we know how strongly Gold Futures reacted to a call between the U.S. and China.

A Long Strangle options strategy may be appropriate under these circumstances. Investor would purchase a Call and a Put option with a different strike price: an out-of-the-money (OTM) call option and an OTM put option simultaneously on the same wheat futures contract. This is based on my belief that wheat futures price could experience a very large movement, but I am unsure of which direction the move will take.

The following is an illustration (not an actual trading strategy):
September Wheat Futures (ZWU2) is quoted at 10.54/bushel on June 14th. An OTM call with a $12.00 strike price is quoted at 17 cents. An OTM put with a $9.00 strike price is quoted at 4.625 cents. Look at the chart again, you will see wheat price at $7.80 right before the war and up to $13.70 in early March.

A Long Strangle will cost $1,081.25, as each call and put contract is based on 5,000 bushels of Chicago wheat. This is the maximum amount you would lose if wheat price stuck at current level in the next two months. A big move, either up or down, could make one of the two trades profitable, and hopefully with enough profit margins to cover the other losing trade.

Happy Trading.

Disclaimers
*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.

24 ביוני 2022

הערה

September Wheat Futures (ZWU2) is quoted at 10.54/bushel on June 14th. An OTM call with a $12.00 strike price is quoted at 17 cents. An OTM put with a $9.00 strike price is quoted at 4.625 cents.
On 6/24, our Put value went up 788% to over 40 cents/bushels. If we sell all our positions, the return would be +141% for a 10-day holding period.