Minimum Value—When Suppliers Won’t Play

In physical futures markets, large numbers of participants, simply by bidding for or offering these markets’ goods, engage in price discovery. For our purposes,their efforts here can be very helpful under certain circumstances. When there is too much of a physical commodity, we’ll sooner or later see the famous bear market, and we’ve an excellent opportunity when such a bear market meets a few conditions. What will be the low price in December corn this year? I haven’t a clue and have no intention of trying to guess it,for there’s no need.

Whether coffee or cocoa, cotton or crude, if a physical futures market is in considerable oversupply, the market itself will very kindly tell us when to make a dollar.In any physical market, the economic notion of minimum value applies.There is a hard, objective price for the product, below which producers will sharply curtail production or stop producing altogether. No point in engaging in commercial activity if you can’t turn a profit, is there?

Clearly,this effective minimum value varies from producer to producer, and by market and year. Can we determine what this price area level is at a specific time, either actually or approximately?We can get close to figuring this price point, but we need a little help.First and foremost, we want to observe a particular type of event that hints to us that minimum value is close at hand.

I call this a trigger event. In late 1999, citizens of the Ivory Coast made the newswires worldwide, first by threatening to and subsequently by actually dumping great piles of low-grade cocoa in the streets and burning them. Evidently a number of growers were so frustrated/annoyed/furious at persistently low world cocoa prices that they ultimately decided such action was the only way to express their anger and/or plead for higher government subsidies.

Bingo. This is a dandy trigger event, nearly a perfect one. I couldn’t put a hard number to it at the time, but minimum value was lurking somewhere in the current price neighborhood. When producers spontaneously begin destroying their own production, how in the world can the market price not be close to minimum value? Opportunities like this are certainly not everyday occurrences, but they come along sufficiently often that we ignore them only to our detriment.

Turning Facts into Dollars—How to Do It and Why It Works:Earning a profit in such situations is a remarkably likely result and involves applying an easy, straightforward strategy. We’ll write short-dated puts immediately under the market and, for the most part, sit still. If the front-month cocoa futures are at a price of 780, we’ll write the short-dated 750 puts; if the market is 820, we’ll write the 800s, or just possibly the 750s if the potential ROC of the trade is satisfactory.

If we’re alert and a little bit nimble,we can occasionally manage to execute this trade profitably for several successive months.“Aw, come on, Stu! First you say that when I write options, I should write ’em way out of the money, now you want me to snuggle the strike I write right up to the current market price. You can’t have it both ways!” Oh yes I can, and I do. In usual option-writing strategies, we much prefer to write short- and shorter-dated options as far away from the market as is convenient and consistent with a positive expectation and a solid ROC.

Here,we’re not dealing with the usual case, though—we not only have Sister Theta on our team, we also have her little brother, human economic rationality, hitting right behind her in the lineup, and it gets better still. Batting behind human nature comes our long-time friend historical tendency—and he knows how to hit this pitcher, believe me. This lineup is trading’s equivalent of the famed Yankees’ “Murderer’s Row” of old.

Theta’s on our side because, in the bear market situation just described for cocoa, we’ll elect to write short-dated puts, typically with four to eight weeks until expiration. Human nature is under contract to us this time because people won’t produce, or won’t deliver goods to market, if they earn nothing or nearly nothing in return. History is way in our favor because of a very interesting fact about bear markets in physical futures, one which admits of precisely no historical exception.

We have even one more thing going for us here. What is a market, ultimately?I claim—and I’m 100% willing to stake my capital on this definition,and economics professors who disagree be damned—that it is an anticipatory discounting mechanism of price. Yesterday’s news is worth nothing,and today’s little or nothing, save in extreme cases such as Hussein invading Kuwait on August 1, 1990. The market participants have discounted to a considerable extent whatever supply/demand information has been available, and ordinary news will have little effect on their or our future decisions.