Synthetic Positions Explained

5/6/2017

"I'm trying to explain degree of difficulty does not get you more points," Calipari said. "Like the harder shot you try to take, there's no four-pointers, unless you get fouled on a three-pointer. So, that's a hard one for him. I'm trying to get him to just make easy plays." - John Calipari

So what can John Calipari teach about grain marketing? What he is trying to say is that there are easy ways to win games and hard ways to lose games. A win is a win, so why not try easier plays? The analogy works the same in the realm of grain marketing. There are times when the odds favor you to make sales and there are times when it works against you. If you need to pull the trigger but don't see much reward for your risk, then why not look at other asset types which could be substituted for corn or soybeans? Why make a hard trade when you can make an easy trade? In the paper trading world, it is possible to improve your odds of success sometimes by switching to another asset which has more potential to achieve the results you are looking for.

According to Wikipedia, a synthetic position is a way to create the payoff of a financial instrument using other financial instruments. Moneywords explains that synthetic financial instruments are artificially created investment vehicles or instruments intended to meet requirements not met by existing conventional instruments. In my view there are many times when the standard corn or soybean position just does not look very attractive. When corn and soybean fundamentals are poor, perhaps wheat and oil could be used instead.

Why Use Synthetic Positions

I like making marketing decisions when a commodity is at a place I call "actionable", which means that its price is at an extreme. This is why I follow cycles and sentiment. We know the tendencies of anything which is traded on an exchange because of cycles. A cycle is how an asset bounces along from bottom to bottom. Take oil for example. The chart below shows that oil trades in yearly cycles, intermediate cycles, and daily cycles just as most all assets do. The cycle counts are different for every asset, but the premise works the same. The cycles are much easier to count with oil than with corn, soybeans or wheat. The grains have too many moving parts, such as North American weather, South American weather, currency, exports, worldwide supply and demand, etc. for long trending moves most of the time.

I like to couple the cycle counts which I marked on the below chart with sentiment readings. When you take a trade at a cycle low when sentiment readings are excessive, the risk of the market going against you becomes very small. This usually only happens at intermediate and yearly cycle bottoms which normally happen 2-3 times a year. I only recommend synthetic trades at yearly and intermediate cycle bottoms.

Long or Short Oil

The synthetic positions I talk about on this website come in two types. The first type I wish to talk about is buying or selling oil futures. To a greater or lesser degree, oil and grain tend to move in the same direction. This could have as much to do with currencies as anything else, but when you remove the seasonal tendencies of grains on a shorter term basis, prices of grains tend to follow oil.

Oil prices move in a more predictable fashion than grains do. Grains chop around, and except for seasonal spikes tend to wind up near where they began. Oil on the other hand makes larger trending moves. Yes, it chops around sometimes at major tops or bottoms, but you can realize gains riding moves out of intermediate and yearly cycle lows. I have recommended two synthetic trades on the website so far. There was the long trade out of an intermediate cycle low back late August, and more recently a short off of an intermediate cycle high in December. These kinds of trades will net 30 - 60 cents per bushel equivalent on average.

Selling Puts

The second type of synthetic positions I talk about here is selling put options. 80% of all options expire worthless, so why not take advantage of dull trading times to collect some option premium? Writing put options is considered a bullish strategy.

Once the crop size is determined, prices tend to flatten out for months at a time. There is no longer fear of running out, especially in large surplus years such as this year, so prices will not rally enough to create good marketing opportunities. It is important to use cycles and sentiment to determine the optimal times to sell put options. You hope to time your sale at an intermediate cycle low, and you want to catch the market when sentiment readings are extremely oversold. Just like long and short futures, selling options is marginal so we want to do what we can to avoid margin calls and to stack the odds in your favor. Managing the trade risk is easier at cycle bottoms also. Prices which are not at an extreme have a 50/50 chance of going up or going down. I don't like those odds.

In December, corn prices were flat and below most producers break even costs. Wheat, however, was still a big question mark in terms of how big the crop would be. The opportunities for rapid price appreciation for a small wheat crop were much better than the opportunities for corn following a bin busting crop.

What follows is the set up for the synthetic corn long position using wheat puts we did back in December. Why would I recommend a bullish strategy using wheat when wheat was at the lowest price in 10 years? The two main reasons were the cycles and sentiment.

The multi year wheat chart below shows that prices were at their lowest level in 10 years. I recommended selling wheat puts when the price was at $4.02.

The daily cycle for the March wheat contract averaged about 24 days. (See the cycle counts on the below chart) The bottom of the wheat market occurred only 12 days into its new daily cycle. This also marked the beginning of a new intermediate cycle. We sold just enough time to take us out a couple months.....just long enough for a short dated option to expire before an intermediate cycle decline would be expected to begin.

So the cycles were saying to buy wheat, but Sentiment levels were at excessively pessimistic levels also. This is the fuel for all major market rallies.

A person who recognizes this can feel confident selling put options at the bottom of the intermediate cycle. While wheat was presenting this opportunity, the corn chart was giving no clues as to what direction prices would go.

The optimism index was also giving no hints as to what direction price might go.

So if you are wanting to make a sound marketing move to help your bottom line, why would you choose to sell corn when its sister commodity wheat has all the parameters of a great trade? The wheat puts added .35 to our corn sales. Doing this removed the pressure to make a grain sale and gave us more time to catch a weather rally later to sell physical bushels.

But Mr. Wade...... Isn't this speculating? Technically speaking, I suppose it is. It certainly isn't hedging. Technically speaking, you are speculating the day you drop your planter into the ground, but you plant anyway. These positions which I write about are tied to your farming. They create value. The risk is defined, just as your farming is when you take a loan. My goal is not to create more risk, and I don't believe this kind of trading does.

Keep an eye on crude oil. I am expecting the parameters will be in place to do a synthetic oil long trade in the next week.

0 Comments