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Drought or No Drought, Lower Corn Prices Could Be on the Way

On Tuesday I discussed how the sizzling heat in the Midwest is negatively affecting the corn crop, driving prices higher.

As it turns out, this drought isn’t just bad. It’s the worst the area’s seen in 24 years. And it’s expected to get worse!

That means corn prices could very well charge higher from here. And investors playing the upside would continue to cash in.

But there’s another factor to consider that could soon force corn prices lower…

A “Triple-Top” Could Be Forming

I mentioned before that corn was flirting with its all-time high of $8 per bushel, which means that the commodity is forming a “”triple-top chart pattern.

However, now that the December 2012 futures contracts are getting close to $8 per bushel I think it’s time to take another look…

 

As you can see, this is the third time corn has approached $8 (which is where “triple-top” comes from). The problem is that each time corn traded in this price range it plummeted rapidly.

So if the December 2012 corn futures don’t blast through the $8 level soon, they could end up dropping as much as $3 or $4 per bushel.

That’s precisely why the triple-top chart pattern is one of the most bearish indicators you can get. And if it proves accurate this time around, investors who are only playing the upside might get burned in the near future.

So while being bullish on corn is certainly popular right now, I thought I’d show you a profitable way to play the downside, too.

The Perfect Bearish Play on Corn

The best way to take advantage of a future dip in corn prices is by selling slightly out-of-the-money call option credit spreads.

That might sound complicated, especially if you aren’t very familiar with options. But the practice is relatively straightforward.

Here’s how this type of trade would work…

To enter a spread, you would sell the $8.50 call option in the December 2012 corn options market. And at the same time, you’d buy the $8.60 call option.

For each spread you’d end up with $0.03 – the difference between the premiums for the options. But remember, $0.01 in the corn market translates to $50 for investors. So you’d actually end up with $150 as your maximum gain per spread.

And as long as corn stays below $8.50 by the December expiration, you keep that money.

However, if corn ends up blasting to $8.60 at expiration, you’d be hit with the maximum loss on this trade. That turns out to be $0.07 per spread, or $350.

So the potential loss is bigger than the potential gain, but considering that December corn futures are currently trading at $7.87, you’d have about $0.60 per bushel of fluctuation before taking any kind of hit.

That’s the beauty of this strategy: It gives you plenty of room for error. And as long as you’re confident about the bearish assessment of the market, then this could be the right trade for you.

If not, it might be best to wait around another month to see how the weather shapes up before pulling the trigger.

Ahead of the tape,

Lee Lowell

Lee Lowell

, Chief Options Analyst

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