By Brad Zigler
Bulls looking for sweet landing spots on the commodity landscape have had some pretty slim pickings recently. Coffee and corn made explosive upside moves recently, making other commodities look positively limp by comparison. There are a couple of budding bull markets — not rocket-powered, by any means — that look promising, though. One of them is sugar (the other is natural gas, but we’ll talk about that in another column).
We last wrote about this market a month ago (“The Volatility Headwind In Sugar”) decrying the fat volatility premia embedded in sugar option costs.
When the article was published on June 7, spot sugar was 14.35 cents a pound and offers for option contracts were pretty rich. In fact, they still are. It’s taking a while to wring the volatility out of the sugar option market. A case in point: over the past 20 days, the volatility in sugar futures was clocked at 36 percent; it was 41 percent for the most recent 100-day period. It’s slowly losing the volatility built up from the earlier price free fall.
As high as the underlying markets historic volatility is, the future volatility implied by option premia is a lot higher. October 17.5-cent calls, for example, last settled at a penny (that’s one cent times 112,000 pounds, or $1,120). That’s pretty rich. There’s a 44 percent volatility assumption for the 70-day option (it actually expires in September; “October” refers to its underlying futures contract which last settled at 16.70 cents a pound).
Last month, we thought the iPath Dow Jones-UBS Sugar Total Return Subindex ETN (NYSEARCA:SGG) — a futures-tracking note issued by Barclays Bank plc. — would be the simplest and cheapest way to get long on sugar. Not cheap in the dollar sense, necessarily. After all, the notes were selling for $40.60 a copy back then. A round lot would have cost your cash account $4,060 before transaction fees. (With SGG now at $46.31, SGG investors have been well-compensated, however.)
So, what if you didn’t buy SGG a month ago? Is there still room for upside in the sugar market?
Well, yes. But as prices climb, volatility is likely to moderate.
We examined some sugar market fundamentals pointing to higher prices in “A Commodity Market Sweet Spot.”
Weekly ICE/NYBT Sugar #11
(Click to enlarge)
But let’s reconsider those options. With a penny premium for the October 17.5-cent call, you could buy four options for the same cost as a round lot of the SGG notes. With an 18.5-cent expiration date breakeven, though, you’re not fully exposed to sugar’s upside. The option’s delta — the expected sensitivity to price changes in the underlying futures — is only 45 percent now. Simply put, that means a penny change in October sugar futures today moves the option’s value by just 0.45 cents.
These options, however, could be used to give you more leverage in the sugar market. You could for example, buy in-the-money calls — say, the October 16-cent contracts at 1.61 cents — and use the simultaneous sale of the 17.5-cent struck options to partially finance the deal.
The combined position, known as a bull call spread, breaks even at $16.61 at the mid-September contract expiry — less than the futures’ current market price. How safe is that?
And the cost? The 0.61-cent difference in the option premia (from buying the 16-cent call for 1.61 cents and selling the 17.5-cent contract for 1.00 cents). For the cost of an SGG round lot, you can snag six or seven spreads (the net premium of each is $683).
Your downside’s limited to the spread’s net cost and would be fully realized only if October sugar was at 16 cents or less on September 10. The trade-off for this constrained risk is a check on your potential profit. No matter how high October sugar may rocket — if sugar rockets — you’ll make no more than 0.89 cents a pound (the 1.50-cent difference in strike prices less the 0.61-cent spread cost). That leaves you with a reward-to-risk ratio of 1.46.
That’s not bad, really. Anything above 1.00 means you’re getting decent compensation for the risk undertaken.
It’s, in fact, a pretty sweet deal.
Disclosure: No positions