Going Against The Grain?

Corn/Oats Spread

The prices of corn and oats show a high statistical correlation. A similar growing season and the commonality of being used in the animal feed market explain this relationship. However, there are occasions where a move in one of these markets is followed by only a muted response or no response at all in the other market. These are the times when a spread trade opportunity can show up. Right now may be one of those opportunities.

Corn Oats Overlay Monthly

Corn Oats Overlay Monthly

With the US (the world’s largest corn grower) expected to harvest a record corn crop and Canada (the world’s second-largest oat grower) simultaneously producing the smallest oat crop in over two decades, there has been a divergence between the two markets. While most grains (including corn) plummeted to multi-year lows over the last couple of months, the oat market has been stuck in a trading range.

Corn Oats Spread Monthly

Corn Oats Spread Monthly

In the last four decades, there have only been a half-dozen times when the corn/oat spread has been at 50-cents or lower (basis the nearest-futures) on the monthly closing chart. Additionally, a ratio of 1.2:1 or lower has only been seen a handful of time in the same time span. Trades at ‘even money’ (when corn and oats are at the same price) have been even less frequent. The normal level for the relationship between corn and oats is around a premium of $1-per-bushel (premium corn) or 1.7:1.

Corn Oats Ratio Monthly

Corn Oats Ratio Monthly

The nearest-delivery contract September corn/oat spread sank below ‘even money’ in early August and oats have held the premium since then. The corn traded at a discount of as much as eighteen cents to the oat market last week. The problem, however, is that the First Notice Day for the September grain contracts is two days from now. This leaves no time to make a trade in these contracts. Therefore, traders should be monitoring the December spread.

While not quite as extreme as the September spread, the December corn/oat spread is still historically quite low. Right now the spread between the December corn contract and the December oat contract is +23 cents (premium corn). It touched a contract low of +16 cents on Monday. Unless a trend change occurs, the Christmas spread could be destined to trade below the ‘even money’ level as well.

Trend Change Signals

There are two simple signals that traders can use to identify a possible bullish trend change for the December corn/oat spread:

First, a close above the declining 30-day Moving Average (currently around +33 3/4 cents) would be noteworthy. The spread has not closed above the 30-day MA since early May. Plus, the 30-day MA proved accurate when it closed above the 30-day MA on March 6th to signal a bullish trend and it proved accurate when it closed back below the 30-day MA on May 13th to signal a bearish trend. The bearish trend has obviously not been negated yet.

December Corn Oats Spread Daily

December Corn Oats Spread Daily

Secondly, a breakout above the August high (currently at +43 cents) would alter the bearish price structure. The December corn/oat spread has not broken a previous month’s high since this year’s high was established on May 8th.

Trade Strategy:

For tracking purposes, the blog will make a hypothetical trade by buying one 5,000 bushel December corn contract and simultaneously selling one 5,000 bushel December oat contract if the spread closes above the declining 30-day Moving Average. Initially, the spread will be liquidated on a two-consecutive day close 5 cents below the contract low that precedes the entry.

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Livestock Spread: Trade Signal Triggered

Feeders/Live Cattle Spread

Welcome to the rodeo! On August 21st, just a day after our very first post, the Nov-Dec feeder/live cattle spread closed below the rising 50-day Moving Average for the first time in over four months. This triggered a hypothetical trade for the blog to sell one 50,000 lb. November feeder cattle contract at 207.35 and buy one 40,000 lb. December live cattle contract at 148.60 for a spread of 58.75 (premium feeders).

Nov-Dec Feeder/Live Cattle Spread Daily

Nov-Dec Feeder/Live Cattle Spread Daily

The contract high for the spread was made on August 12th at 64.30. Therefore, our initial hypothetical position exit signal will be a two-consecutive day close above 64.80 (or .50 points above the contract high).

Note that the tick value of $5 on the feeder cattle contract is slightly higher than the tick value of $4 on the live cattle contract. To normalize the tick size, a trader should have four feeder contracts for every five live cattle contracts.

Once a downtrend is firmly established in the Nov-Dec feeder/live cattle spread, we may discuss potential ideas for measuring volatility to determine intervals for adding to a spread position. Stay tuned!

 

Almost Time to Take the Bull by the Horns?

Feeders/Live Cattle Spread

The difference between feeder cattle and live cattle is simply based on where the animal is at in terms of the cattle cycle. Feeders are the calves (usually 6-8 months old) that have been placed in the feedlots to fatten up. They usually weigh in between 650 and 850 pounds. Once the feeders have grown to a weight of 1,000 lbs. or more, they are considered ‘fat’ or live cattle. Normally, it takes about four or five months for the feeders to reach this weight level. At that point, they are ready to be shipped to the packers for slaughter.

Because feeder cattle and live cattle are the same animal at different points of the cattle cycle, it should come as no surprise that the prices of these two markets are highly correlated. By viewing almost four decades of price history, one can readily see that these two markets are highly correlated as they almost seem to move in lockstep with each other.

feeders_live cattle overlay monthly

Feeders/Live Cattle Overlay Monthly

Although feeders and live cattle move together tightly, there are still going to be times when one of these markets will be grossly overpriced/under-priced compared to the other. Right now is one of those times.

Historically, there have been several times when the feeders gained a premium of 20 cents or more over the live cattle. It never lasted, though. Each time the spread reversed and narrowed. Over the last decade, however, the spread has made new historical highs before reversing. Between 2004 and 2006 the feeders traded either side of a 32-cent premium before the trend finally reversed. The feeder/live cattle spread did not see the 32-cent level again until 2012. That year it raced to a new all-time high of nearly 41 cents before it crashed back to Earth.

Feeders/Live Cattle Spread Monthly

Feeders/Live Cattle Spread Monthly

Here in 2014, the spread between feeders and live cattle surged to a new all-time high. History suggests that this will once again reverse. Therefore, spread traders should be watching for a setup to get short.

The problem with looking at the feeder/live cattle spread by itself, however, is that both the feeders and the live cattle have also traded to new all-time highs in terms of absolute price. Therefore, we should look at the relationship between the two markets not only in terms of the spread between them, but also in terms of the ratio between the two markets. The ratio can normalize the extremes of a spread relationship. It comes in quite handy as a useful filter to measure when a spread is ‘expensive’ or ‘cheap’ if the underlying market prices are also at historic extremes.

Looking at four decades of history, there have only been a handful of times that the feeder/live cattle ratio has made it to 1.3:1 or higher on the monthly nearest-futures chart. This summer the ratio reached an all-time high of 1.43:1. The nearest-futures weekly chart shows that the ratio is still around this level. Therefore, we can say with certainty that the feeders are trading at an historic extreme against the live cattle.

Feeders/Live Cattle Ratio Monthly

Feeders/Live Cattle Ratio Monthly

Looking at the end-of-year contracts, the relationship between November feeder cattle and December live cattle is at lofty heights. The spread is currently around 61.75 (premium feeders) and the ratio is at 1.41:1. From a trader’s perspective, this might be the spread to watch for a potential trade opportunity.

November Feeders/December Live Cattle Spread Daily

November Feeders/December Live Cattle Spread Daily

 

Trade Strategy:

Here are two possible trend change signals for the Nov-Dec feeder/live cattle spread:

First, a close below the rising 50-day Moving Average (currently around 60.17) for the first time in over four months could be indicate that the bull market is over.

Secondly, a break of the July low of 57.35 would mark the first time since February that the spread has traded below a prior month’s low. This would alter the bullish price structure of higher monthly highs and higher monthly lows. If the July low is not breached by the time September starts, the trend change signal could be raised to a break of the August low.

Once a trend change signal is triggered, consider it negated on a two-consecutive day close .50 points above the contract high (currently 64.30) that precedes the trend change signal.

Just for grins, the blog will make a hypothetical trade by shorting one 50,000 lb. November feeder cattle contract and simultaneously buying one 40,000 lb. December live cattle contract if the spread closes below the 50-day MA. Initially, the spread will be liquidated on a two-consecutive day close .50 points above the contract high (currently 64.30) that precedes the trend change signal.