Coffee, Natural Gas Markets Offer Seasonal Plays For Option Sellers

by: James Cordier

Professional option sellers James Cordier and Michael Gross discuss potential high-yield option plays for Affluent Investors in May:

(Video Transcript)

James Cordier and Michael Gross

Michael: Hello, everyone. This is Michael Gross, Director of Research here at I'm here with Head Trader, James Cordier, with your monthly Option Sellers Audio/Video Podcast. James, welcome to the show.

James: Thank you, Michael. As always, it's a pleasure.

Michael: We are going to talk a little bit about what's going on in the world right now, and we are going to get into some of our key markets for this month. James, obviously anybody watching the news this month has had quite a bit to look at. We have North Korean missile test, we have Russian bombers flying over the Alaskan Coast, so there's a lot of geo-political things going on in the world right now. It's bringing a lot of instability into a lot of people's thoughts about what may be going on over the next several months in the markets. The VIX and the S&P is up 24% in one week here in April as a result of a lot of this. So, just overall, what's your take on the month of April as far as the markets go?

James: It's interesting, Michael. Over the last 6-8 years, we've had very little of the news that we're looking at recently. There's a lot of muscle flexing going on by both Russia and the United States, and maybe China coming up soon. It does have Wall Street a little bit jittery. As you said, the VIX is up some 24% recently and, actually, I think the VIX was testing multi-year lows. So, it always seems that something comes down the pipe to give everyone jitters, and I saw the stock markets sold off here recently on some of the concerns going on around the Middle East and throughout Syria and North Korea. I think that's a necessity to keep traders on their toes and to make sure the stock market and other markets aren't always on a one-way street. A lot of the traders like the hustle and bustle of the markets going up and down, and I guess we do, too.

Michael: Well, we'll see what happens. I know there's been a lot of articles as of late. Ron Insana of CNBC, they recently had an article on their website talking about the two things that most often start bear markets and one of them was rising interest rates and the other one was the onset of war. So, let's hope we don't have anything like that, but something to keep in mind as you're planning your stock portfolio or stock option portfolio for the spring and summer months here. Over on this side, we're going to get into some of the commodities that we feel may be offering some opportunity this month. First on our list is we're going to talk about the natural gas market. Obviously, energy markets is some of the most seasonal markets in commodities. Natural gas, during the month of May, can be a very seasonal commodity. James, you want to give your take on that right now and what you see happening there?

James: Michael, thank you. It's very interesting throughout the year of the 12 commodities we follow. There will be certain times, sometimes the first quarter and sometimes the second quarter of the year, that a certain commodity has the propensity to go up or down based on seasonality. Natural gas is certainly one of those. Generally, natural gas prices will rally during the months of March, April, and May, and then we start building supplies for summer cooling needs. What a lot of people are not familiar with is the fact that to cool vs. to hear requires only 10% of the natural gas that it does during the winter months. So, quite often, natural gas has a rally going into spring and summer thinking, "Well, it might be a hot summer" and it turns out that natural gas usage to cool homes and businesses in the winter is like 10% of what it takes to heat homes and businesses in the winter. Subsequently, the rallies in spring and summer do falter. Supplies of natural gas coincide this year with the seasonality of the market falling. We're approximately 16% here in the United States over the five-year average. What's so interesting right now, Michael, is areas like the Permian Basin, which has new drilling for oil, new production for oil, and a lot of people talk about energy that way. The Permian Basin has supplied new production records for the first five months of this year. That's expected to continue. Natural gas production in the United States to pull a million BTUs cost approximately $1. We have natural gas prices trading around $3-$3.50 per million BTUs. That's a whole lot of anchor pulling this market down when you can produce something for one-third of what you can sell it for. That's a lot of downward pressure. We think that natural gas at around $3.50 right now per million BTUs is probably fair value for this time of the year. Going on to summer and fall, we probably expect natural gas to tweak down to around $3, and for seasonality traders and for what we're doing for our clients right now is we're positioning for weaker natural gas prices for the fall and winter of this year. We are selling natural gas options, right now, double the price of the current value. This is one of our favorite seasonal plays for 2017. We just started walking into it recently and, I think, later this fall and winter, a lot of these natural gas calls that we're selling will likely be worthless and should definitely add to one's portfolio this year.

Michael: James, that's a good point. You're talking about those contract months that are going a little bit further out, and you're already looking at winter 2017-2018. When we're looking at the supplies right now, as you talked about, we are 14-16% above the five-year average for natural gas supplies, and when you're talking about the seasonal and you have a situation right now where this winter is over, supply is starting to build again. As the supplies start to build, obviously, that means you have higher supply in storage that also coincides with lower prices because as supply rises price often goes down. So, what you're saying is we'll go to the back contract months and take advantage of what we expect to be lower summer prices. That doesn't mean we're going to be getting those options all the way to December or January. If we do get to that decline, we could get out of these quite a bit sooner.

James: Exactly, Michael. A lot of our clients and some of the people following us today are very familiar with what we call the early buy-back. Generally speaking, if you are writing options in a portfolio, of course, if you have a portfolio with us you're familiar with this, if you're selling options for $700-800 per contract and you see them trading six months later at $70-80 per contract, that's a perfect candidate for an early buyback. We will very unlikely hold these options until they mature this December and January. Of course, they mature or expire, should I say, a month before they're named. Odds probably in October or November, a lot of the options that we're selling now will probably be worth 10% of their initial price - very good candidates for early buybacks. A lot of investors who sell options in their portfolio, they are talking about selling 60-90 day options. We feel that the sweet spot for selling options if further out than that. The small movements that happen in the market, technical buying, technical selling, if you sell too short period of time, these small moves can knock you out of your position. We don't want a headline to knock us out of our position, and that's why we sell further out in time and price. If the sweet spot for selling options was a tighter amount of days, like 30 or 60 days, that's what we would do. We feel that the opportunities for very high probability option selling is further out in time. We're paid to wait and that's what we do. Patience is the name of the game. When you're selling based on fundamentals, it gives you the patience to stay into a market. When you're selling an option simply because, "Well, the decay is supposed to be the quickest between 60 and 90 days" and the market goes against you, you don't know why you're in that position, and that makes it very difficult to have patience and the wherewithal to stay with a market. If you're selling options based on fundamentals like this position would be, when the market goes against you a little bit, it allows you to hang onto the position. Quite often, they're going to expire worthless. You need to be patient. As long as the fundamental is on your side, you don't mind waiting.

Michael: Okay. Let's talk a little bit more about that buyback. We were going to do this at the end, but since you got into it now, let's go ahead and talk about it now. It's an important point a lot of people, when they're first getting into selling options, especially commodity options, they're thinking that same point you brought up - "Oh, I need to sell 30-60 days." Obviously, we prefer to sell longer than that because, often times, you'll get a primarily portion of that decay long before those options are every scheduled to expire. So, a question I often get is, "Well, how do you know when to buy it back? What level do you wait for before you buy it back?" That's probably a good question for you to answer. What do you look for?

James: Sure. Once an option has decayed 85-90%, the majority of that premium is pure risk. When you're collecting $700, the option is trading at $70, you really need to do very little homework after that. You've collected 90% of the potential premium. Buying back an option with 90 or 100 days still remaining on it, we do this, as you know, quite often. If the option is trading at 60 or 70 and there's 100 days left on it, that option's going to sit at that price for a long time. At that point, you're really not getting paid to keep that risk involved in your account by holding that position. 9 times out of 10 that option is going to go to zero. 9 times out of 10 it would have been an okay idea to hang onto it. When managing portfolios, the risk/reward is always what you base all of your ideas on. You've collected 90% of the premium, you no longer have to watch the weather, you don't have to watch the supplies, you don't have to look at the calendar, you just need to place the order and buy the option back.

Michael: Yeah, that's a good question. Before the show here today, we actually had a client visit. One of the things he was asking was, he was looking at his account saying, "Boy, I see we have a lot of expirations scheduled for September, October, November. Will it be then I can expect to realize the profits on these options?" That was the exact point I was explaining to him - no, not necessarily. You could be taking profits on these things in June, July, August if everything is going well. That was a point, especially if you're new to commodities option selling or option selling in general, it's a big point to realize - we're not always holding these things to expiration. In fact, most of the time, you probably can buy them back early and cut that risk and put that capital into a different investment. If you'd like to learn more about the early buybacks and looking at the fundamentals in some of these markets, the best resource we can recommend is our book, The Complete Guide to Option Selling: Third Edition. You can get it on our website at a little bit less than you're going to pay at a bookstore or on Amazon. The link is, if you'd like to get your copy there. James, let's move into our second market for this month. One of your all-time favorite markets: the coffee market. Right now, we're at a key point in time where we're right ahead of the Brazilian harvest. That can bring a very interesting seasonal into play, one that option sellers can use to their advantage. James, you want to give the overall synopsis of that market right now?

James: Certainly, Michael. In 2016, parts of Brazilian's coffee belt did experience extremely dry conditions and here's where you need to do your homework just a little bit. Brazil is basically just a ginormous farm, whether it's cocoa or soybeans or coffee or sugar, basically that's what the Brazilian nation is made of. The coffee belt is enormous. In 2016, there were dry conditions in a lot of the coffee growing regions. It was primarily in the Robusta region of Brazil. We trade primarily Arabica coffee. The Arabica crop was doing extremely well last year, but all you heard about was the driest conditions in 15 years in Brazil. It primarily was hurting the Robusta crop. The Arabica crop did receive plenty of rain. That volatility and that news headlines that coffee was getting last year pumped up, especially coffee calls, giving it historic volatility that will now create extremely expensive coffee options this year, next year, and probably 3-4 years out. Believe it or not, it does hang on that long. This year, 2017-2018 crop, is the off-cycle year; however, Brazil is expected to produce nearly 50 million bags of coffee this year. Next year, the on-cycle for production would be approximately 60 million bags. This type of production doesn't mean that coffee will never rise in price. Sometimes, it will fall, and sometimes, it will go up. This prevents the really large move in a certain direction. When you're able to make coffee beans to that extent, to kind of give you a focus idea, not that long ago Columbia was the largest producer of coffee, producing 10 or 20 million bags of coffee. Everyone counted on Columbian beans to supply the world. Brazil is now making 50 and 60 million bags of coffee. This year's expected to be an off-cycle crop record year. Next year will likely be a record production year in Brazilian coffee. That is production that we see coming down the pike. How are supplies now? In the United States, it was just broadcast this past Monday that coffee supplies in the United States are at the largest level since they've been counting coffee beans starting in 2002. So, supplies here in the United States are at all-time highs. Production in the next 2-3 years is expected to be a record. Seasonality for coffee, as it normally rallies in April or May, the Brazilian starts in earnest in June, July, and August, these coffee beans then are looking for a home. That's when prices tend to fall. Coffee recently has rallied up to 140-145 level. Selling coffee calls for late this year, beginning of next year, is just a sweet spot and an ideal candidate for option selling going forward for this year. The natural gas looks like a very good opportunity. Coffee is just a great way to diversify your account. We really love the aspects for coffee to be having probably an overabundance supply over the next year or two. We'll be looking at selling coffee calls this year and next. Generally, you sell them in March and April and the market starts to fall as Brazilian products come in June and July. This year looks like it's a good setup, as well.

Michael: James, we've already had a pretty good downward move in coffee, and I know you've been selling these most of the month. One thing I noticed is even with that downward move in prices, that volatility that we got from the drought you talked about back in the fall, that's still in the market. So, you can see, even though you've had a downward move in prices, you can still sell coffee calls so much further above the market. That's just the added value of that volatility that's still working in there.

James: The volatility is something, as we were discussing earlier, the VIX on Wall Street rallied some 24%. Volatility allows someone who maybe has missed a position or I missed a buy or I missed a sell on options, or basically anything else. On commodity options, that volatility allows the person who did get in on the low and the market's rallying, you still have time to sell puts. A market that's falling and you didn't get in on the sell on gold calls or coffee calls or whatever it happened to be, that volatility allows you to not have to be in on the high or low day. The volatility still stays there and really gives the person the ability to take their fundamental analysis, put the position on even though you didn't catch the low, you didn't catch the high. The coffee market did weaken recently, just like we expected it to. We think that selling calls in coffee on subsequent rallies is still going to be a very good idea.

Michael: So, the market's over sold right now and we get a little bump, that might be an opportunity for some people that are watching this that might want to look to enter. That might be a good opportunity for doing that.

James: We've been selling coffee calls with both hands here recently and it did just slide over the last week or so. The months of May usually has some up-turns in coffee, so we're not expecting that coffee is going to be down and out for the rest of the year. We would expect some higher priced days in the coming month of May. We will be looking at that to add into our short position in coffee, yes.

Michael: So, much like in the grain market, as the harvest begins supply start to rise and as supply rises that often contributes to an overall lower gravitational pull of prices. That's what James is talking about taking advantage of here. If you would like to learn more about this trade and the coffee market, you can look at our blog post on coffee that was posted earlier this month. That is available on the blog. If you're interested in learning more about the natural gas market, that is going to be the feature in our upcoming May Newsletter. You can certainly take a look at that. That should be in your mailbox and e-mail box somewhere on or around May 1st. Keep a lookout for that. We also have a good feature in there this month on proper diversification and some of the best ways high-net-worth investors can use to diversify into alternative investments. Keep an eye out for that. James, I believe we've covered the topics we wanted to cover this month. For those of you who are interested in a potential managed portfolio with our firm, we do have no openings left available in May. We do have a handful still remaining for June, so if you're interested in one of those remaining openings in June, feel free to call the office this month. You can call Rosemary at 800-346-1949. She will schedule you a free consultation. Those will take place during the month of May for June openings, so if you're interested in that, please feel free to give her a call. James, any last words on the markets this month?

James: Diversification really seems to be the word of the year right now. So many investors that seek our guidance and seek accounts with us, that is the word that everyone is using. No one is really quite sure what's going to happen with the stock market or the economy, for that matter, and diversifying away from stocks is something, I think, a lot of investors are doing. We're not sure if this economy is a 4% economy or a 1% economy. Lately, it's going to be the latter, and it's interesting to see how the stock market's going to continue its ascent while that's the case if the economy is slowing. Maybe demand for stocks and certain real estate and such might be waning. This is certainly a sweet spot for us and we certainly enjoy what a lot of investors are seeking right now.

Michael: Well, it should be an interesting summer for stocks. Here in commodities, though, I think it's business as usual and I think we'll just keep doing what we are doing. Well, everybody, we've appreciated you watching this month and we will be back in 30 days. Have a great month of premium collection. We will talk to you in June.