Playing The Continuing Drought Using Options

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 |  Includes: AGA, CORN, JJG
by: William Campbell

Even those who contend global warming is a hoax would have a hard time denying this summer has been extremely hot and dry. Only a couple of weeks ago it seemed as if half of Colorado was on fire. The Midwest is suffering from the worst drought in decades; now covering more than half the U.S., it is the most widespread one since 1956. Although even the climate change "realists" have traditionally been quick to point out the lack of correlation between climate change and any specific weather event, scientists at NOAA recently estimated that global warming increased the likelihood of the current drought in Texas by twentyfold. Farmers on TV have shown dwarf corn plants that should be five feet tall but have scarcely made it to three feet.

What does this mean for the options trader? The looming poor harvest is driving related agriculture commodity prices and futures dramatically higher. The corn crop is irreversibly damaged and corn futures are up about 40% in the past six weeks. The crisis is most acute for corn, but other agricultural commodities, such as wheat and soybeans, will be affected in turn. And the drought is not likely to get better anytime soon. One way to exploit this unfortunate situation is to trade agricultural ETFs and related products.

Many ETFs related to agriculture crop prices would be suitable for a long position but do not have options, including PowerShares DB Agriculture Double Long ETN (NYSEARCA:DAG), iPath Dow Jones UBS Agriculture ETN (NYSEARCA:JJA), iPath DJ-UBS Softs TR Sub-Index ETN (NYSEARCA:JJS), UBS E-Tracs CMCI Agriculture TR ETN (NYSEARCA:UAG), Teucrium Soybean (NYSEARCA:SOYB), Teucrium Agricultural (NYSEARCA:TAGS), and Teucrium Wheat (NYSEARCA:WEAT). There are at least four that do have options: Elements MLCX Grains Index TR ETN (NYSEARCA:GRU), iPath DJ-UBS Grains TR Sub-Index ETN (NYSEARCA:JJG), PowerShares DB Agriculture (NYSEARCA:DBA), and Teucrium Corn (NYSEARCA:CORN). (See the charts below.) GRU is inexpensive at 8.54 and its options are thinly traded. DBA is an unleveraged and unfocused ETF, with exposure to commodities ranging from cocoa to livestock. Its recent changes are much more subdued than those in JJG and CORN. iPath DJ-UBS Grains TR Sub-Index ETN (JJG) is an unleveraged ETN focused mostly on corn and soybeans. CORN is an unleveraged fund whose NAV reflects a weighted average for three different corn futures contracts. PowerShares Agriculture ETN (NYSEARCA:AGA) is a two times inverse ETN equally weighted between corn, wheat, soybeans, and sugar. PowerShares Agriculture Short ETN (NYSEARCA:ADZ) is a one times inverse ETN. Neither ADZ nor AGA have options.

A summer rally in corn futures is not new. For corn futures ($CORN) during previous droughts, the increases were as follows: 2004, 56%; 2007, 80%; 2008, 146%; and 2011, 129%. This summer the increase has only been 40% so far. Given that this year's drought is even worse than in those years, it seems likely prices will continue to go up. For JJG, past peak prices occurred on June 30, 2008, June 1, 2009, and Aug. 22, 2011. Given the relentless pace of climate change, a seasonal spike in crop futures may become commonplace.

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There are several ways to trade drought options. The premiums for CORN and JJG have become very expensive, with comparable-month call premiums about 37% higher for CORN than JJG.

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With the run-up and overbought conditions, a risk-tolerant gunslinger might buy call options and a contrarian might buy put options. But the best way to take advantage of high-priced premiums is to sell options. An aggressive trader might elect to do a short straddle or a strangle, while one less risk-tolerant a butterfly or iron condor. A conservative way to take advantage of the situation is to play a covered call.

JJG is slightly more attractive than CORN for several reasons. JJG has a longer history and has had an even greater run-up than CORN. JJG did not decline between March 2012 and June 2012 as CORN did. If a top is near, given the historical peaks it will likely come soon. Both JJG and CORN have August options, but the premiums aren't so attractive. JJG has October options, but the next CORN options are in November.

The annualized return from an exercised covered call selling the first OTM call is 31% for the November CORN and 30% for the October JJG. A collar using the next strike put below breakeven for October JJG would buy the 55 put; this still produces an annualized return of 19%. My favorite strategy is to pay for the long put by selling short puts: the covered call ratio spread. Buying the 60 put and selling two of the 55 puts leaves the put side even and preserves the 30% profit. JJG has crumbled slowly after past run-ups, taking several days to drop below the 50-day SMA, so there should be time to unwind the position when appropriate.

Alternatively, you could forget the collar strategy completely and go long AGA. The chart below shows the reciprocal relationship between JJG and AGA. AGA is on sale, and an eventual AGA rally seems as inevitable as an eventual JJG decline.

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Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in JJG over the next 72 hours.