Protein Makes a Difference
Although the Chicago wheat contract is the world benchmark for wheat prices, the Minneapolis and Kansas City wheat contracts normally trade at a premium to the CBOT wheat. This is because the Minneapolis hard red spring wheat and Kansas City hard red winter wheat are a higher protein content and, therefore, higher quality product that the CBOT soft red winter wheat. The Minneapolis and Kansas City wheat is what buyers purchase for food production.
As you would probably suspect, the price behavior of these three wheat contracts are highly correlated. However, there are times when one or two of the markets will outperform the other. This is where the spread opportunity lies.
Normally, the Kansas City wheat contract will have a markup of roughly 10% over the CBOT wheat contract. At ‘normal’ levels, you can flip a coin to determine which way the spread will go. There’s not much of an edge at this level so we ignore it.
Our antennas go up when KC wheat climbs to a premium of 20% or more over the CBOT wheat. This has happened about a handful of times in the last four decades. It never lasted. This indicates that a premium of 20% or more makes the KC/Chicago wheat spread a short sale candidate.
On the other side of the coin, we start getting interested in the long side of the trade when Chicago wheat starts trading at a premium to KC wheat and we start getting involved when CBOT reaches a premium of 5% or more. At that point, the KC/Chicago wheat ratio is at 0.95:1 or lower. This has only happened twice in the last decade and a little more than half a dozen times in the last forty-five years. Ultimately, things would reverse and Kansas City wheat would go back to trading at a 10% premium over CBOT wheat. In price terms, the KC wheat would normally go back to a premium of 35 to 40 cents or more over the Chicago wheat.
The Current Situation
Thanks to the rains that pounded the Midwest right before the harvest, the soft wheat growing region suffered a drop in crop size. This is in addition to the fact that the seeded area was already below the five-year average.
This direct hit to the soft wheat crop allowed the Kansas City wheat to fall well below the price of the CBOT wheat. The nearest-futures spread dropped into the red (pun intended) by more than 20 cents. This has only happened half a dozen times in nearly half a century of trading. This has been a great buying opportunity in the past, so that’s the side of the trade we want to focus on.
The spread between the December contracts did not sink as low as the nearest-futures September contract, but it still inverted. This qualifies it as a trade candidate.
On August 31st the December KC/Chicago wheat spread closed with the KC wheat at a premium for the first time in nearly four weeks. The spread then backed off.
The declining 50-day Moving Average is now in close proximity to the August 31st bounce high. A breakout above the August 31st bounce high of +2 3/4 cents (premium KC wheat) and a close above the 50-day MA for the first time since mid-May would signal a bullish trend change for the spread. This could indicate that the inversion is over and that a return to normal is underway. If so, spread traders would have a good reason to get positioned on the long side.
We’re going to work a hypothetical order to buy one December Kansas City wheat contract and simultaneously sell one December Chicago wheat contract if the spread closes at +3 cents (premium KC wheat) or higher. If filled, we will initially risk a two-day close of three cents below the contract low that precedes the entry.