Option Selling Opportunities So Good They're Scary

by: James Cordier

Video Transcript

October 2018 Podcast

James Cordier and Michael Gross

Michael: Hello and welcome to OptionSellers.com October Podcast. Happy Halloween to everyone. You'll notice we are back doing our podcast in video format this month. The title of this month's podcast is "Option Selling Opportunities So Good They're Scary"... in the spirit of the month. Speaking of scary, James, U.S. stock market is sure taking some ups and downs this month.

James: The stock market certainly has. So many people making warnings about it being too high and some of the things coming down the pike recently. Generally, interest rates and hikes in interest rates often slow down bull markets in the stock market, and certainly, that's what appears to be happening right now. Earnings right now seem to be exceptional. What's interesting is, and we talking about this a couple times in our last one or two podcasts, Michael, is that the rest of the global economy, China and all throughout Asia and lots of Europe are slowing, in some cases dramatically. How much longer can the U.S. economy continue to trudge forward doing extremely well while the rest of the globe is not doing so good? It'll be interesting to see. We've got a shot across the bow these past two weeks with the stock market. We'll see if it's a buying opportunity or if maybe something has changed and maybe the direction is maybe going to head down now.

Michael: It's certainly one of those things we're looking at. Matt mentioned something to me earlier when we were having a conversation in your office. It's that all the news right now, they're focused on these wild swings in stocks, the big dive, the bounces, and over here in commodities, it's kind of all quiet right now.

James: It really has been. So often, people consider commodities quite a large volatile investment. In fact, it does have swings... 1%, 2%, 3%. People come on CNBC and Bloomberg and talk about the big move in metals or energies that particular day, but what always happens in commodities is 1, 2, or 3 weeks later it reverts to the means. Commodities have supply/demand factors, and right now, they seem quite stable, and so has been the price over the last 3-6 months.

Michael: Yeah, I don't think they get the media, as well, because the media starts talking about these stock moves and it causes all these investors to pile in, you have all this public interest in the stock market, everybody starts selling at once like the herd, where [in] commodities you don't really have all of that media coverage and you don't have as much public participation. I think it probably adds a little bit of insulation to that sort of thing. Wouldn't you agree?

James: Michael, I think that's a great description. Commodities, unlike stocks, have end-users and producers. Whether it's crude oil or gold or coffee, if it gets too far away from its fair value, there's someone there to take advantage of it. If something's too low, for example coffee prices have really crashed below $1 recently, I wouldn't be surprised if companies like Starbucks (NASDAQ:SBUX) were saying, "We'll take some of that at $0.95 and we'll hold onto that forever".

Michael: Well, speaking of coffee, I think it might be time to move into our key market segment now. Why don't we go to the trading room? We are going to talk about two markets this month that, if you're looking for something else other than equities that are uncorrelated, we're going to get into that. Why don't we go to the trading room and get into this month's markets?

Michael: Welcome to our Market segment of this month's podcast. This month, we're going to talk about a couple option selling opportunities that are so good they're scary... in the spirit of the season. [The] first market we're going to talk about this month is gold. James, we're talking a lot between the two of us outside about the stock market this month. We talk a lot about markets being diversified in completely uncorrelated equities. Gold is a little bit correlated to equities but not in the fact that it moves with equities, but it can be affected by the price of equities. We're going to talk about, first, gold prices have been falling substantially here over the last several months. What are some of the reasons why it has been falling?

James: You know, gold really falls out of favor when you see the stock market making new highs every couple of days. Basically, the stock market in June, July, August, and September, all the news is it's making record highs and probably going higher. The Federal Reserve is on an even keel, and basically, the safe haven demand for gold really takes a back seat when stocks are doing quite well. There seems to be very little inflation. The Federal Reserve is on a course to raise interest rates slowly but steadily, and the real fear idea or the safe haven idea really goes out the window. Of course, gold doesn't have an interest-bearing level. Basically, you're investing in it, and if it goes nowhere or falls in value, there's no dividend certainly. Safe haven buying is one of the big aspects as why gold does rally, and has rallied in the past. Right now, we're missing that quite a bit, or at least we had been until just a couple weeks ago.

Michael: As you mentioned, the dollar as well with the Fed raising rates here, the dollar has been going up... other countries not raising them as much, a lot of international investors instead of buying gold they've bought the dollar as a safe haven. That's why we've seen this rally. You see that leveling off a little bit here now. Maybe the dollar's big reign here may be coming to an end.

James: It may be. Just touching a little bit on gold and the dollar and why the dollar is such a headwind for gold pricing. Basically, here in the U.S., are we consumers of gold? Yes, we are. Do Americans like to buy gold? Yes, they do. Asia, China, and India, that's where the real gold buyers are. When their currency is weakening or it's in a bit of a downfall like it has been versus the U.S. dollar, the gold market gets quite expensive. When gold is falling, or any commodity falls... basically, low prices cure low prices, unless they're valued in a currency that continues to increase in value. That is one of the reasons why gold has just really languished at low levels because of the strong dollar. We do think, and we can talk more about it, but we do think that's probably coming to an end, as the Federal Reserve is possibly looking at a little bit more dovish stance.

Michael: Of course, as everybody knows and we talked about it earlier, we've also had this big drop in the stock market, a lot of volatility in stocks as of late. Obviously, we had the big October drop here. That's been bringing some interest into the gold market, as well. Stocks down over 4% in October. At that same time, gold off the lows is actually up 3% in October, so we're seeing some buying almost directly correlated to this equities drop.

James: You know, the stock market has really been getting a lot of warnings from some really large investors, and some really large money managers have been talking about possible correction in the stock market, and it's really tough to ignore that. The people of BlackRock and Blackstone are saying, "Look out below". It's kind of tough to ignore that. The stock market certainly has come down quite a bit. I believe we're now lower on the year. What's so interesting is all we've heard about is record highs every day, so it's interesting how the market can give back in just a short period of time when it took 6 months to make. Safe haven buying is coming back, interest rates are probably not going to increase every quarter, and that should reduce the value of the U.S. dollar. The stock market is definitely a two-way street right now. It's not just a straight up-move anymore. I think a lot of investors are looking at global economies around the world and how can China be easing and European Union be easing and the U.S. economy continue to increase. I think a lot of people are crying uncle on that, and I think gold has probably made its low for the year and we see it starting to work higher in the coming quarters.

Michael: You mentioned the Fed, a little bit more dovish outlook going into 2019. Can you talk a little bit about why we see that and why is the Fed taking their foot off the gas a little bit right now?

James: Well, we've been talking about trying to gather inflation. Inflation is one of the best things that can make an economy continue to grow. I know 60 or 70 years ago inflation was a dirty word, but it's not anymore. Everyone's trying to get inflation for their economy, whether it be Asia, Europe, or here in the United States. Inflation is very good for an economy. When the prices are falling, what do people do? They wait and they don't buy. Why should we buy now when we can get it cheaper tomorrow? Inflation is a very strong propellant for economies around the world. The fact that the Federal Reserve is going to raise rates now when inflation is just peeking its head above 2% doesn't make a lot of sense. I think a lot of people are coming to that feeling, so the fact that we're not going to be raising rates they might let inflation run hot just a little bit in order to help other economies around the world. It's giving people the idea that the Fed is going to turn dovish, and that's going to be either slightly positive or very positive for gold going forward.

Michael: Yeah, I agree with that. I also think they're probably a little bit worried about the global economy right now. You have the thing with China that isn't going away. We know, since we talked about in the opening, we see slowing growth in Europe. It's expected to, I think, grow 1.9% next year, 1.7% in 2020, and that's huge export market for the United States. You take China and Europe, the two biggest export markets of the United States, there's issues with both of them, they're probably looking out a little bit at that saying, "We don't want to jump the gun here". As you mentioned earlier, pressure from the current administration probably isn't helping any, as well.

James: You know, it's hard to continue in raising rates when everyone else is saying, "Why do we need to do this?" The Fed chairman's boss is really, really pounding the table on we don't need to raise rates quite so fast. It's tough to ignore that, as well.

Michael: Obviously, gold is kind of an indicator of inflation. Any indication that inflation's going up is going to be a catalyst for gold. We talked about two reasons now where you see the tide turning here for gold. You have the more dovish Fed, you have the volatile stock market, but something that a lot of people might be underestimating now is the upcoming midterms. I think that may be bringing a little more concern into the markets than a lot of people talk about.

James: Absolutely. The midterms could really change the landscape of the economy going forward. Right now it's too early to call, and I think the pollsters haven't been doing such a good job over the last few years, so a lot of people don't want to talk about the polls based on the fact that they haven't been very good both here and in Europe when they're trying to predict the Brexit. They didn't get that one right for sure. The last presidential election, they didn't have that one right. The houses, if they change power, that's going to change - in possible dramatic fashion - the economic outlook. Boy, there's more uncertainty, and there's nothing gold likes more than outcomes that they're not quite sure about.

Michael: We're feeling gold is now at value levels, and again, we don't try and call lows, but you think it's probably getting in a range here where it's goodbye instead of trying to call the low. We're looking to sell options. Do you want to explain our strategy here, James, on what you're thinking?

James: Michael, you know, what's interesting about selling options on commodities or anything else really is that here was the perfect time to buy gold. Of course, it's very difficult to do when it's just crashing and everyone starts talking about $1,000 gold, but in here somewhere over the last 4-5 weeks, we've had a fundamental change. So, yes, we missed the low in gold. If you're a futures trader or if you're a day trader, you had some nice consolidation here. We broke through this resistance right here. We're now looking possibly forming a bull flag. That may or may not be one, but going long from $1,100 when demand for gold right now is just extreme. Gold can either come down to [gestures at chart] this level, this level, this level, it could stay the same, or it could rally. As long as it stays, of course, above the $1,100 level, the premium winds up being captured and it's a winning position. The idea about selling options is we have a lot of volatility right now and, believe it or not, these $1,100 puts are still quite expensive. I know it looks like it's a long way out-of-the-money, it does look like it's probably not going to be reached, but right now investors are spending $500, $550, $600 to buy this option. I'd be a big seller to that right now.

Michael: So, you're recommending the August $1,100. That gets us out there far enough, decent premium, $500. Roughly, what would you say the margin on these is? What would the investor have to put up to get these premiums?

James: The margin is less than 2 to 1. So, you're taking in about $500-600 for each one you sell. The margin requirement is about $800-900. It's a quite small margin requirement to hold this position, and it makes it quite easy to put in a portfolio.

Michael: Once you put it on, if that value does start decaying, the margin requirement goes away with it. So, your margin requirement drops, and whether that expires and you keep the full $500 or, oftentimes, you're looking to get out of these 2, 3, 4 months early, right?

James: That's right, Michael. We sell options probably much further out in time and in price than most people that are involved with doing this, not with the idea that we're going to stay in the option until the very last day trying to collect the very last dollar. That's really not necessary. If you sell options fairly well - sometimes we do - if you sell options fairly well, that option should lose probably 75-80% of its value in about half of the time that's remaining on the option. So, quite often we'll be buying options back that have 100 days remaining left on them, with the idea that you've captured 90% of that premium. Once it gets down to that low level, that's really a good time to cause a buyback candidate and cash in the profit and start over anew.

Michael: Very good. James, let's move on to our second market this month. We're going to talk a little bit about one of our favorite markets.

Michael: Now we're going to talk about one of our favorite markets to trade when selling options in commodities. That is the coffee market. You may have seen us feature this market about 2 months ago. At that time, we were talking about the fundamentals. James, you were looking for a potential rally in this market in October as an opportunity to potentially sell call options, and it looks like we're getting that rally now. What do you see happening here in this market?

James: What's interesting, Michael, right now the coffee market was really beat down to extreme low levels in August and September. We actually breached $1 a pound on the downside, which we haven't seen in a couple years. Mainly, it was certainly the coffee crop right now in Brazil is doing well, the coffee production in Indonesia and Vietnam are doing quite well, but the Brazilian real continued to lose value. There's a lot of uncertainty going on in that country right now, and they have an election coming up. That was pushing the real down, that was pushing coffee and sugar down to levels we haven't seen in quite some time. The funds were really pushing it to extreme low levels. We thought a rally would probably come in the month of October, based on maybe weather concerns or some of the trading that's going on right now where investors have been way too short this market. Lo and behold, the Brazilian real has recovered quite a bit. Right now, funds are covering short positions and coffee has rallied from approximately $1 up to the low $1.20s and has nothing to do with fundamentals, the supply and demand. It's a rally based on trading, it's a rally based on a stronger real, and it's really playing into our hands, we think, starting right now.

Michael: That's an interesting conversation to have, as well. As you and I were talking, oftentimes when you talk about the seasonal tendency in coffee and you get that rally in October, it's a weather thing. You have that dry weather pattern, and then the wet weather comes after it, and you're saying they had perfect weather this year in Brazil. It's not weather, it's really speculative funds just short-covering the positions right now bringing a rally.

James: That's exactly right. There were record shorts in coffee for the first 3 quarters of this year. They're now covering their positions. It has very little to do with supply and demand. Vietnam is looking at a record crop this year. Weather conditions in Brazil, by far the largest producer in the world, is absolutely ideal. It is a greenhouse right now. Once the short-covering ends and once the Brazilian real stops making its moves that it has done recently, we'll be back to supply and demand. Starting probably in November and December, the value of the real will mean not so much. The shorts will have covered their positions, and we think that selling coffee in the next 30 days is going to be an excellent idea.

Michael: You mentioned that in the newsletter about the weather and if it starts raining in Brazil it should help bring prices down. It is raining in Brazil now. That comes out here in a couple of days. That could probably help hamper coffee. Let's go back and talk to why we're bearish coffee in the first place. That's the fundamentals. We've got to start at Brazil and Brazilian production this year.

James: You know, Brazil is the largest coffee producer in the world. Back in the day, Colombia was the largest, producing 10 million bags of coffee each year. Brazil now produces 60 million bags of coffee each year. Vietnam, who used to not basically be any type of a coffee producer at all, they barely played in that game, they're now producing 30 million bags. So, has coffee consumption gone up slightly throughout the world? It has, but not nearly to keep up with the supply of coffee. Here in the United States, green coffee stocks are at a 14-year high. Brazil is just done harvesting a record crop. Right now, flowering is taking place in about 8 of the 10 regions in Brazil where they grow coffee. I was just checking the weather map here just a little while ago and it's just absolutely ideal conditions, so we're going to have coffee flowing like we can't believe over the next 6-12 months, on top of huge supplies. I really like what we see here. Coffee is not going to continue this rally very much. Boy, the levels you can sell coffee calls at coming up right now look really attractive.

Michael: Good. Yes, so we have the 60 million bags they just finished harvesting, and the weather looks good for development into next year's crop already. The second-largest producer, Vietnam, they're looking at a potential record crop this year as well, as you mentioned. Bearish fundamentals, supply-wise, that's why you think we're not going to rally too far. We also have a pretty good seasonal we're dealing with now. You just covered that a little bit, but do you kind of want to explain what tends to happen here?

James: Seasonality for coffee is everyone gets very concerned with weather conditions in the largest growing nation in the world. That is Brazil. This is when trees start to flower in September, October, and November. A flowering tree means the tree is looking for moisture to create cherries. The cherries become picked, they become red, and then they become green, and then you roast them. This is usually a time frame when the weather in Brazil can basically change from dry to wet, and then the market falls as weather conditions improve. They've improved already. We have had a nice rally here in October, the seasonality is lining up almost ideal, and we don't have a crystal ball, but it certainly feels like - based on fundamentals and the conditions in Brazil - that this seasonality is going to take place once the fear of any dry conditions is over. Coffee has slid in the past, and there are no conditions right now weather-wise that's going to keep this chart from forming again this year, I think.

Michael: We talk about that spike you sometimes see in October, that's what you're looking at right there. It's showing that often in October you get some type of rally. We're thinking that's what this is here. I know that's what you're looking at, and it could be exactly what that is.

James: It looks exactly like that.

Michael: So, as an opportunity, you have this rally in the face of these bearish fundamentals. Obviously, that strategy we're going to be looking at selling calls in this market.

James: Michael, the fundamentals for coffee brought it all the way down below $1. This has been short-covering, this has been a stronger real. Supply and demand is going to exist where coffee trades between $1 a pound and $1.05 a pound later on. This rally, this $0.20 rally, is going to allow option sales as high as $2 a pound, we think, coming up. When coffee returns to what we think is its fair value, it'll probably be half of the call strikes that we sell. That's what's shaping up. There's never any guarantees, but it certainly looks about just an ideal situation right now.

Michael: You and I have been looking at a number of different strikes and priced a number of different premiums and strategies for our managed portfolios, but for the investors watching at home right now, maybe who want to take a look at something for themselves, we've put something together for them here. Do you want to explain that?

James: Okay. This is July 19th, so this position will last approximately 6 months if it was taken all the way until expiration. Coffee right now is trading around 1.20 a pound. The 1.85 call right now is selling for about $500-600 each. As long as coffee, of course, stays below 1.85 - and we certainly think it will - that option expires worthless. July is an interesting time frame. This option would actually expire in the month of June, and if we go back to the seasonality - we can always do that at any time - the seasonality is coffee is usually near its low in June, July, and August, and that's when these would expire. We love being short at 1.85. If you're going a little bit further, you can sell the $2 call depending on someone's time frame, but for ease of your home viewers, that I think is a great sale. It's about 40-50% out-of-the-money after a $0.20 rally already. The timing looks pretty good.

Michael: If this thing tanks like it does on the seasonal, you're probably looking at getting out of those a little bit early. If it keeps going up or it keeps going sideways, maybe you've got to stay in them longer, but as long as it stays below that strike, you're ultimately probably going to have a pretty good result.

James: My best guess is in the month of March or April, maybe April or May, that option will probably have lost 80-90% of its value already, so you don't have to stay in it all the way until June if you don't want to.

Michael: We hope you've enjoyed this month's podcast, and we hope you learned a little something you didn't know before you started watching the video this month. James, thanks for your insights on the markets this month.

James: My pleasure, Michael. Certainly lots of opportunities, I think, coming up, and we'll wait and see and how the end of the 4th quarter shapes up as we go into October and November.

Michael: Thanks for watching this month, and we'll see you again next month.