Commodities Roundup: Seasonal Tendencies: The Option Seller's Ace in the Hole
James Cordier, Michael Gross, OptionSellers.com
October 28, 2011
If there has ever been a more controversial, misunderstood, overregulated, in vogue and out of vogue “predictor” of market direction, it has been seasonal tendencies in commodities.
There was an author that came out with a book several years ago that made himself semi-famous overnight by publishing a series of “can’t lose” commodity trades based on seasonal tendencies. For those out of the know, seasonal tendencies refers to the price of a certain commodity moving in a certain direction during a certain time of year.
This gentleman was big for a few years. He got himself some TV appearances. Started publishing a newsletter. Had a few high profile calls on the market. And then, everybody found out that you “could lose” trading commodities. And the whole phenomenon faded pretty quickly and people stopped paying attention to seasonals.
Seasonal Price tendencies often develop as a result of certain commodity "events" that happen at the same time each year.
All of this, of course, is a shame for the investing public for it was a clear case of throwing the baby out with the bathwater. Used correctly, seasonal tendencies can be a powerful tool for commodities investors. I felt them so important that we devoted two full chapters to seasonals in our book, The Complete Guide to Option Selling.
The good news is that seasonal tendencies are still alive and well in the commodities markets and available to anyone that wishes to interpret their compelling data. No, they are not perfect. But they cannot be discounted as a major fundamental factor in almost any commodity market. In fact, I often use it as a starting point when analyzing new option trades using our strategy.
Seasonal tendencies do have their drawbacks. First and foremost, past performance is not indicative of future results. Just because it happened last year, or even the last 10 years, doesn't mean it's going to happen this year. Season tendencies are just that, tendencies. This means prices have, in the past, tended to move in a certain direction during a certain time of year. However, there are no guarantees as to what point in that time period prices will move, how far they will move, or if they will even move at all. There are no promises made that prices will not spasm sharply in the opposite direction than they are “supposed” to move, right before aligning with a seasonal tendency.
It is true that season tendencies have their limitations. However, it is my guess that the difficulties of seasonal analysis are more of a problem for futures traders than option sellers. Futures traders have the burden of having to pick market direction and have nearly perfect timing. This makes trading futures contracts in line with seasonals more difficult.
For option sellers, however, seasonal analysis can pack a more powerful payload. As if you need more reasons to sell options, option sellers are not burdened with the responsibility of perfect timing, they can withstand short term moves against their position and they are more than willing to wait for a move to occur. After all, as an option seller, you have all the time in the world.
This fact alone, in my opinion, makes seasonal tendencies and option selling a potent combination. But one cannot blindly assume that prices will automatically move in a manner consistent with a seasonal chart. Seasonal tendencies are driven by underlying fundamentals that tend to happen at the same time each year. For instance, grain prices tend to remain strong through springtime in the US, when anxiety about planting is at it's highest. Once the crop is safely planted in the ground, much of that anxiety is lifted. Thus, in the past, grain prices have tended to weaken once the planting season is finished in May.
The mistake that novice traders make with seasonals is the assumption that seasonals provide you with an exact roadmap of what prices should do. The novice may assume from the chart below that if you buy corn on October 1, and sell it February 28th, you will be assured a profit. It's just not that simple. What if harvest finishes early or the crop comes in smaller than expected? Prices could react sooner and you would miss the move. What if the crop comes in larger than expected or something happens to crimp demand? You could buy right before the market begins an "unexpected" move lower, or simply doesn't move at all.
Caption: A 5 year seasonal chart of March Corn shows on average, corn prices have tended to rise beginning in the month of October. You must consider, however, that this chart represents a mere average and that individual years can vary depending on overall fundamentals. Nonetheless, seasonal charts can be an invaluable tool to fundamentally based option sellers.
Note to Chart Readers: The numbers on the right of the chart do not represent absolute prices but rather, a percentage of lowest and highest price for the year. It is the overall pattern on which option selling investors should place their focus.
This is why Option Selling is preferable to trying to trade the actual contracts on a seasonal move. The option seller can still see his option expire worthless if he is early, late, or even if the move does not occur at all. Only in an extreme counter-seasonal move does the option seller lose. Not so for the futures trader.
You must also be careful not to discount the relative nature of seasonal tendencies. Think of the opposing factors moving different commodities prices as two weights on either side of a seesaw. Rarely is all the weight on one side. Seasonal factors can put more weight on one side of the seesaw. However, that does not mean that an even heavier counterweight cannot come down on the other side - negating the seasonal effect. A wise option seller should always give seasonals their due. But they should be taken within the context of the overall fundamental and technical picture.
We often consult seasonal tendencies when considering positions for our option selling portfolios and I believe they can be an invaluable tool for option sellers. Just don’t always take them at face value. It helps to know the fundamentals driving these tendencies. However, it has been my experience that combining seasonal tendencies with the strategy of selling options can be a powerful combination. Working with an experienced professional can be of substantial benefit when interpreting seasonal tendencies.