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Options for Small Traders to Follow the Smart Money in Grains

Options for Small Traders to Follow the Smart Money in Grains

Grain markets are accessible to small traders in a number of ways. For futures traders, grains can be attractive because the contracts have low margin requirements and low volatility. This makes them ideal for learning how to trade futures.

For futures traders, margin has a different definition than it does for investors in the stock market. In the stock market, margin involves borrowing money from your broker to increase the buying power of your account.

In the futures markets, margin is a deposit that the broker requires to open a trade. The amount of margin varies from market to market. For crude oil, the margin requirement is more than $4,000 per contract. For corn, the minimum margin is just $1,275 per contract.

Futures brokers deduct any losses from the margin deposit and they set margins based on the volatility of the contract. Grain contracts, like corn and wheat, tend to have low volatility. These two factors, low costs and low volatility, make them a great starting place for new traders.

Futures Traders Know What Other Traders Are Doing

There are many differences between futures and stocks but one of the benefits of futures is the accessibility of information about what other traders are doing. This level of detail is not available in the stock market.

For futures markets, the Commodity Futures Trading Commission (CFTC) collects and publishes detailed data on what different traders are doing. The CFTC is the regulator of futures markets, serving a role that is similar to the Securities and Exchange Commission (SEC) in the stock markets.

Every week, the CFTC releases a report called the Commitment of Traders (COT) which provides insight into the market action. Large traders are required to report their positions every week and this allows the CFTC to classify traders into one of three groups.

Large speculators are traders holding several thousand contracts in an individual market. These traders include hedge funds and large institutions. Commercial traders are those that use the futures markets to hedge their commercial activities. In grain markets, farmers would be an example of commercials. All other traders are considered to be small speculators.

The COT report identifies the positions of each group. Analysts have developed techniques to analyze this data with some general assumptions.

Generally, commercial traders are considered the “smart money” and small speculators are viewed as the “dumb money.” Commercials are in the best position to understand the market, which makes them the smart money. Small speculators are individual futures traders and they are believed to be wrong more often than they are right, making them the dumb money.

Large speculators tend to be trend followers. They will generally be wrong at major turning points but they will be on the right side of major trends. For many analysts, this group can be ignored because the opinions of the smart money commercials and dumb money small speculators offers insight.

Putting COT Data to Work

Raw CFTC data can be difficult to interpret. The report itself is a collection of numbers provided in text format by the regulator. An example is shown below.

Because the report can be difficult to interpret, some data services convert the data into an index. In the chart below, the data has been converted into an index showing the degree of bullishness or bearishness relative to the past six months.

At the bottom of the chart, commercials are shown as the green line and small speculators are shown as the red line. Vertical blue lines mark times when small speculators, the dumb money, has become excessively bullish.

The blue lines actually show turning points in the sentiment of small speculators. Remember that only a small margin deposit is required to open a trade and losses are deducted from that deposit at the close of every trading day. Because traders are using leverage, small price moves can result in large losses in dollar terms.

As small speculators become increasingly bullish, the red line in the chart rises. If they are wrong, and prices are falling or moving against them, their losses are mounting. The turning points in the indicator are where small speculators are throwing in the towel, so to speak, and cutting their losses by closing the position.

In the past, these have marked important turning points in the price of corn. Corn has tended to fall sharply after the buying of small speculators stops.

Turning our attention to the green line in the chart we can see how commercials feel about the market. They are, as a group, strongly bearish. They are called the smart money because, as a group, they tend to be right more often than the they are wrong. Their bearishness confirms that prices are likely to fall.

Trading Grain Markets With Options

In the past few years, exchange traded notes (ETNs) have become available for some commodity markets. An ETN is similar to the more common ETF, or exchange traded fund. The difference is that an ETN will hold derivatives in its portfolio while ETFs hold shares of stock.

This adds an additional risk to ETNs. There is a remote risk that one of the investment firms involved in writing the derivative contracts will default and be unable to meet its obligations. This is a risk but there have not been any defaults in the ETN market, even in 2008 and 2009 when investment firms faced extreme stress.

An ETN is available to track the price of corn, Teucrium Corn ETF (NYSE: CORN). The chart of CORN is shown below. The general price trend is the same as the trend seen for corn futures.

At the bottom of this chart, the stochastics indicator is confirming the potential down move in price. Stochastics is a momentum indicator. It recently completed a bearish crossover with the longer period average (the blue line) falling below the short period average (the magenta line).

In addition, stochastics is showing a bearish divergence. The indicator failed to reach a new high as the price of CORN briefly rallied in the past few weeks. This indicator adds to the bearish outlook for CORN.

A Specific Trading Opportunity

With CORN expected to decline, a bearish options strategy could deliver profits. One way to act on a bearish outlook is by selling a call option.

For CORN, a trader can sell a call option with an exercise price of $19 expiring on September 15 for about $0.45. The risk on this type of trade can be relatively high. The trader faces a loss if CORN is above $19.45 at expiration, which is the breakeven price considering the exercise price and premium received (breakeven = call exercise price + premium).

If, for example, CORN closed at $25 on September 15, the loss would be $5.55 (the current price minus the breakeven price of $25 – $19.45 in this case). Since each contract covers 100 shares, the total loss would be $555.

The maximum gain on this trade is equal to amount of premium received or $0.45, $45 per contract.

To limit the risks, the trader can create a spread. In this case, that can be done by buying a call option with an exercise price of $20 for about $0.15. The expiration date on this contract would be the same as the date of the contract that was bought, or September 15.

The maximum potential loss is now reduced to the difference in the exercise prices of the two contracts less the net premium. The difference in the exercise prices is $1. The net premium received is $0.30 ($0.45 from selling the call less the $0.15 to purchase the second call).

The maximum gain on this credit spread is $30, the amount of premium received when the trade was opened. Overall, this trade provides a potential return of 82% on the amount of risk accepted.