Episode 5: Looking into Natenberg's Option Volatility & Pricing

Three decades of impressive work has made Sheldon Natenberg’s book Option Volatility & Pricing a hefty read, even for those more experienced in options trading. Rodney Connor and Gabe Sheets-Poling take the time to break down learnings and the pricing tools that could make a difference on your farm.

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Rodney: So I thought about you the other day, I'm reading a book that I'm sure you've read a number of times called Option Volatility and Pricing. I think it was a recommendation by you or your team, at least.

Gabe: Sheldon Natenberg!

Rodney: There we go. And you know what struck me in that was, he talks a lot about how the user of an option should never let it expire. That's a big theme of his, so he wants to take advantage of that volatility. I've always been in the camp for a farmer, when he's using options, that he should set it and forget it. I'm just interested to hear how you think about this, because it strikes me as when I own a call option, which is probably the most popular that a farmer's using, and the market's going up, the last thing I want to do is sell that call option. Right? And I, I've been mostly comfortable with that. I'm just curious what you think of that.

Gabe: Sheldon's book, first of all, it was great reading, especially if you're having trouble falling asleep, but it's great.

Rodney: Very light, yeah.

Gabe: But really, that title is telling, Option Volatility and Analysis. It's written for a volatility trader. So I wear two different hats. One of those is, as an option trader, which is how I spend a ton of my career, as a portfolio manager in options. That's all I'm looking at, is volatility. So the idea of holding something to expiration as a hedge, because it gives me a protection against price movement, is irrelevant. Because, all I'm exposed to is volatility. And so those are the positions that I'm managing. And that's distinctly different from a proper hedger. If I've got to price grain, I 100% care about what price the grain's at.

Rodney: And so that's why, when you go read a book, like the Natenberg one, it's important to keep the context in mind. So as a trader, as a vol trader, I'm going to go buy a straddle, or a strangle, which is, I'm going to go buy puts and calls. Not because I think the market's going to do something, but because I'm looking for long exposure to volatility. A farmer would never go buy a put and a call. It makes no sense, right? It's super expensive. Like, "What are you doing?" So, that's kind of the difference there. I think it's useful, if you're trying to get into options, to have a deep understanding from a portfolio management perspective, what needs to be on your mind.

Gabe: But for most people, it's overkill. It should be looked at, like you're talking about. Because if you're buying the option to hedge against price risk, none of the volatility actually matters. The real questions are, kind of that same comparison... Am I willing to sell today? If not, then I should probably look at one of these minimum price strategies to make sure I put on a floor, or done something to smooth out my risk. But in that case, volatility isn't particularly relevant, in and of itself.

Rodney: Yeah. So speaking of volatility, as I've gotten a little more sophisticated in my career, obviously, and used these pricing tools, you start to understand the nuance between which pricing tools you should use in any given situation. Right?

Gabe: Mm-hmm.

Rodney: And, typically, volatility plays the largest role in that. I'm always cognizant of the fact of exactly what you just said, which is, don't let volatility get in the way of locking in a good price. Don't make a volatility decision based on price. Or, sorry, don't make a bad pricing decision based on volatility, is essentially what I'm trying to say.

Gabe: Yeah, I got you.

Rodney: So coronavirus, we're working from home, social distancing, right? As you think about the types of products we should be using, are there any products you would say a farmer should absolutely not be using right now, like stay away from?

Gabe: Sure. I would say, if you've gotten yourself to the place where you're comfortable pricing grain, I probably wouldn't get long again, because that's going to be the intuition. Every time we make a pricing decision, if the market happens to go up the next day, that's going to feel really painful. But given where we are in the year, we're mid-March, likely you haven't priced most, if anything, that you're expecting to grow. And so if you are taking some risk off the table, that's great if that worked for you. But again, a common response is, "When we do see that market rally, we'll be able to get long again." And so I'd really encourage people to look at their full expected crop, and how it's priced, and not get hung up on the 10, 20, 30% I made a decision on.

Rodney: I think that's the trouble we can get into in these stressful environments, is really questioning hedging decisions that we made that took risk off the table. And I would really focus on making sure you take care of what's un-priced. So, that's where I think. Now if you've got a really robust plan, and you've got a strong view on the market, and you're like, "Oh, if we get down to three bucks in corn, that's the floor, and it's going to go back up," well, that's a different situation. But most of the time when I see people do that, I'm talking about those behavioral models again. The moment somebody calls me about wanting to fix a contract, that's a clear sign to me, you call a timeout and say, "What are we doing here?"

Gabe: Because they're probably really focused on one little thing that feels really painful, and so it flows to the top of our mind. When, in fact, they've got a whole lot of other great stuff going on, and that decision they made probably actually wasn't a bad decision. And so that's the advice I'd give to somebody who's wondering what not to do.

Rodney: Thanks for listening to the GrainWaves  podcast. If you'd like to learn more about how Indigo can help your farm be more profitable, you can find us here.

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