The Grain Basket Spread
Most commodity traders are trading the closest delivery month contracts in the futures markets. This is where most of the liquidity is. Rightly so. The closer deliveries are more sensitive to changes in supply and demand. This causes them to move around more than the back month futures contracts. The greater market volatility often means more trading opportunities. However, trading opportunities can sometimes materialize in the distant-month contracts where they are seemingly hidden from the majority of traders. These opportunities develop under the radar as most traders don’t usually even monitor the distant month futures contracts, much less trade them.
We are of the opinion that some lucrative trading opportunities may currently be shaping up in distant delivery month futures contracts. Specifically, we are examining the grain markets. Here’s what we have ‘bean’ looking at:
Grain Markets: The ‘Big Three’
Our focus will be on three different grain markets: soybeans, corn, and wheat. Soybeans are the second-largest crop in the United States, corn is the largest crop in the United States, and wheat is the fourth-largest crop in the United States.
(Attach the weekly soybean, corn, and wheat overlay).
As you might expect, the relationship between soybeans, corn, and wheat is highly correlated. These grain markets have similar growing seasons (wheat actually has an additional growing season as well so both spring wheat and winter wheat are planted and harvested during the year) as they are planted in the spring and then harvested in the fall. So if a summer drought affected the beans it most likely harmed the corn and wheat, too. And if ideal growing conditions produced a bumper crop in corn then beans and wheat probably didn’t come off looking too shabby, either. This causes grains to generally trend in the same direction. Other factors such as the overall health of the global economy, demand for bio-fuels, and currency exchange rates have an impact on grain prices as well.
On the other hand, there are times when fundamental events will have a great impact on one particular grain crop and a muted influence on the other two. For instance, a summer drought in Russia may not directly hit corn and beans while it decimates the wheat crop. And if weather problems in South America cause demand for US soybeans to surge it may not have a direct impact on corn or wheat. These sorts of events can cause disparities in the relationship between grain markets, some of them quite significant. The disparities tend to be temporary, though. Several decades of price history reveal that the relationships between these three markets are consistently very strong. In past occurrences where the three markets experienced a divergence it was only a matter of time until they got back in sync. It has always been a question of ‘when’ and not ‘if’ these three amigos get back together. These strong correlations can lead to some great trading opportunities in the grain markets.
Spreading a Basket of Grains
We are analyzing the spread between soybeans and the sum of wheat and corn. We like to call this the ‘grain basket’ spread. To establish a long position in this spread one would need to be long one soybean contract, short one wheat contract, and short one corn contract for each spread position.
The price of the front month July soybean contract is trading about 31 cents over the sum of the price of the July wheat contract and the July corn contract. This is nothing spectacular. Since we are only interested in the spreads that hit levels that are historically extreme, we would simply pass this one by.
Historically, we consider the spread “cheap” when the beans trade at a discount of $1.50 or more under the sum of the wheat and corn. Conversely, we consider the spread “expensive” when the beans trade at a premium of $2.00 or more under the sum of the wheat and corn.
Since the 1960s, there has been only nine times when the spread made it to the upper level of $2.00 or more (premium beans) and about half a dozen times when the spread made it to the lower level of -$1.50 or less (premium the sum of wheat and corn). Most occurrences ultimately led to a reversal that send the spread back to even money and beyond. These were profitable opportunities for sophisticated traders who knew the way this grain basket spread operates.
Rationing the Grains in the Basket
Over the last few years, we’ve seen the grain markets skyrocket to historic highs. Three years ago, the US experienced the worst drought in over half a century. This propelled beans and corn to highs never seen before in history and wheat reached the second-highest price on record. Price extremes can cause the spreads to look extreme as well. To normalize the data, we compare the grain basket spread to the grain basket ratio. This tells us if we are really dealing with a high-probability trade opportunity or if we are just being fooled by price extremes on the underlying market sector.
Based on nearly forty-five years of price data, the ratio between soybeans and the sum of wheat and corn is expensive when it climbs 1.4:1 and it is cheap when it drops to 0.85:1. The ratio has only neared or reached this upper boundary half a dozen times in nearly half a century and it has only experienced the low side of the ratio five or six times in the same period.
Hidden Far Into the Future(s)
Currently, the July grain basket spread is at +31 cents (premium beans) and the July grain basket ratio is at 1.03:1. This is middle-of-the-road levels. As we stated before, it is of no interest to us.
Now here’s something that will make you sit up and take notice: the spread between the 2016 November soybeans and the sum of the December 2016 wheat and December 2016 corn is trading at -88 1/2 cents (premium the sum of wheat and corn). This is $1.19 lower than the nearest-futures July 2015 spread! Although it has not reached the historical extreme of -$1.50 yet, it has been heading that way and it’s a heck of a lot closer than the 2015 spreads are. The Nov-Dec 2016 grain basket spread has dropped about 67 cents from the mid-June peak. If this spread drops another 62 cents from here it will hit the -$1.50 mark.
What’s interesting is these are the 2016 new crop contracts, meaning that they won’t even been planted until next spring. So the growing price imbalance in this spread is for something that doesn’t even exist yet.
The low spread on the 2016 new crop grain basket is confirmed by the ratio. The ratio hit 0.91:1 this morning, which is just a stone’s throw from the 0.85:1 qualifying level.
(Attach the daily Nov-Dec 2016 grain basket ratio).
When to ‘Go Against the Grain’ and Be a Buyer
Examining the daily chart of the Nov-Dec 2016 grain basket spread, we see that this is the sixth time in the last seven months that the spread has dropped to -65 cents or lower. The previous five times, it never closed below -65 cents for more than two days in a row before making a sharp recovery.
This time something has changed. Not only did the spread break price support between the similar December and early June lows, but today could also mark the third day in a row with a close below -65 cents. This is a bearish breakdown.
Currently, we are cheering for a drop to -$1.50 or lower. This would officially qualify the Nov-Dec 2016 grain basket spread as a trade candidate on the long side.
From a pattern-driven outlook, though, a trader could look to go long if the bearish breakout fails. We like to call this the Wash & Rinse signal. It’s where a market cracks price support at a prior low, sets off a bunch of sell stops and algorithm-based sell signals, and then promptly turns right back around. This often leads to a sharp rally. It works in the outright markets and, surprisingly, works just as well in the spreads.
Keep Calm and Trade On
Even if the spread continues to plunge, we know that history indicates that prices at the boundaries on the historic low side don’t last. Especially since the crops for these particular delivery month contracts don’t even exist yet and they won’t even be planted this year! These three crops can be interchangeable from a planting perspective since a lot of acreage can be used to plant beans or corn or wheat. So if the spread/ratio between beans, corn, and wheat is still extremely low when the spring of 2016 rolls around then what farmer is going to want to plant soybeans?! They would obviously have a much higher profit margin in wheat or corn.
But what if the grains see their normal seasonal decline in the next couple of months? Maybe there’s a chance of seeing these long-dated spreads continue to rack up new contract lows. Or what if the Russians ban wheat exports or the Australian wheat crop is destroyed by drought while beans and corn just sit there? This could hammer the spread as well. Perhaps. Or perhaps not. But the important point is that extreme lows like this just don’t last in the grain spreads. The irrevocable Law of Supply and Demand will see to it that the imbalance is corrected. Even if the rally fades and the first attempt at a long position is exited at a loss, the probabilities have not changed. As a matter of fact, they may actually increase since the time duration at such an extreme low will have increased as well.
How to Trade This Spread…And All Spreads
To weather and unforeseeable storms, traders need to exercise sound position-sizing rules (never add to a losing position!) and risk management principles (never bet the farm on any one trade!) in order to stay afloat. Don’t led greed cause you to put on a position size that‘s much larger than is prudent. And don’t let fear or thoughts like ‘it’s different this time’ prevent you from getting back up if the spread gets knocked back down. Stay cool and use common sense. If you can survive the short-term adverse moves, you will be around to capitalize on the long-term probabilities.
For tracking purposes, the blog will make a hypothetical trade by buying one 5,000 bushel November 2016 soybean contract and simultaneously selling one 5,000 bushel December 2016 wheat contract and one 5,000 bushel December 2016 corn contract if the spread between soybeans and the sum of the wheat and corn closes above -70 cents (premium the sum of the wheat and corn). If filled, we will initially risk a two-day close of 5 cents below the contract low that precedes the entry.