Euro Bund/T-note Spread: The Short Position Was Liquidated

The Euro Bund/T-note Spread

On August 24th the blog initiated a short position in the December Euro bund/T-note spread at 27.36 (premium bunds) when the Euro bund closed at 155.99 and the T-note closed at 128-20. The break below the early August low lured us in after the spread probed resistance between a Fibonacci .618 resistance line and the 100-day Moving Average and then rolled over.

On October 26th the spread was liquidated at 29.00 (premium bunds) when the Euro bund closed at 157.59 and the T-note closed at 128-19. This resulted in a loss of approximately -$1,800, not including commissions.

Fundamentally, the rally to new multi-month highs was due to the divergence in monetary policy. With inflation in the Euro zone well below the target level of 2%, the odds are increasing that the ECB will push the deposit rate even further into negative territory from -0.2% to -0.3%. At the same time, the only debate about US interest rates is on the timing of when the Fed will hike, not if they will do it.

Euro bund T-note spread daily (nearest-futures)

Euro bund T-note spread daily (nearest-futures)

The Euro bund/T-note spread blasted its way past price resistance at the July top. This also put it well above the Fibonacci .618 resistance line. Currently, there is nothing to stop it from adding a couple more points and returning to March 3rd the record high of 31.53 where it could form a double top. If the spread makes it up to somewhere close to this level, we will be watching for a potential reversal pattern to take another crack at the short side.

A sustained close above the March high, however, would put the Euro bund/T-note spread in uncharted territory again. There’s no telling how far it can run from there. Don’t fight the trend.

Kansas City/Chicago Wheat Spread: The December Spread Hit New Lows. Still a Buying Opportunity?

Back Under Water

The blog initiated a hypothetical long position in the December KC/Chicago wheat spread at +7 cents (premium KC wheat) on September 4th. The position was then liquidated at -15 cents (premium CBOT wheat) on October 23rd. This resulted in a loss of -$1,100, not including commissions.

KC Wheat Chicago Wheat spread (nearest-futures) daily

KC Wheat Chicago Wheat spread (nearest-futures) daily

The December KC/Chicago wheat spread continues to set new contract lows this morning. It appears to be headed to the double bottom that was made on the nearest-futures chart this summer between the July low of -28 3/4 cents and the August low of -29 cents. If the bear market does not end either side of this area, price support may not be found again until the spread plunges to the September 2007 capitulation low of -61 1/2 cents.

KC Wheat Chicago Wheat ratio (nearest-futures) daily

KC Wheat Chicago Wheat ratio (nearest-futures) daily

Basis the nearest-futures, the Kansas City wheat has been priced at a discount to the Chicago wheat for four consecutive months now. Stated another way, the December Chicago wheat has a premium of 3.65% over the December Kansas City wheat this afternoon and the nearest-futures premium reached a 6% premium two months ago. This is something that rarely occurs. Even during that historic move in September of ’07, the Chicago wheat made it to a premium of not quite 8% before the spread made a violent reversal. Therefore, we are going to reload, get right back in the saddle, and set the parameters for the next shot at the long side of the KC/Chicago wheat spread.

Re-Calibrating the Moving Average

Using the breakout above the declining 50-day Moving Average resulted in a false trend change signal and a losing trade. So we are going to slow things down and, therefore, desensitize the entry signal by employing slower moving average this time around. Bumping the parameters up to a 75-day Moving Average might do the trick.

December KC Wheat Chicago Wheat spread daily (75-day MA)

December KC Wheat Chicago Wheat spread daily (75-day MA)

The early September bounce stayed below the 75-day MA, which kept the downtrend intact. Therefore, the blog will go back in on the long side if the December KC/Chicago wheat spread closes above the 75-day MA for the first time since May.

Trade Strategy:

For a reentry trade, work a hypothetical order to buy one December Kansas City wheat contract and simultaneously sell one December Chicago wheat contract if the spread closes above the declining 75-day Moving Average. If filled, risk a two-day close of three cents below the contract low that precedes the entry.

Platinum/Gold Spread: Multiple Applications For Taking Advantage of This

A Long History

We’ve blogged about the platinum/gold spread several times this year. The spread inverted back in January (when platinum dropped below gold) and has been there ever since, so we have been pursuing it as both a trade and investment opportunity.

Platinum Gold overlay weekly

Platinum Gold overlay weekly

In broad strokes, platinum and gold prices are highly-correlated. While gold is a precious metal and platinum functions as both an industrial metal and a precious metal, the macro trends over the last four decades show that the two markets move in lock-step. When one of these metals gets too far ahead of or behind the other, a spread trade opportunity materializes. This is what happened in 2015.

Buying Opportunities

Since platinum is fifteen times more rare than gold, it normally trades at a price premium over the yellow metal. Once in a while, extreme events will cause the platinum to drop below the price of gold. These have always proven to be temporary events. When the fundamental relationship is restored, platinum reclaims its rightful place and trades at a premium to gold.

In our opinion, any instance where platinum is trading at a discount to gold should be viewed as an opportunity on the long side. To take advantage of it, spread traders would establish a long position in platinum and a short position in gold.

Now, it is important to note that this spread is not a directional bet on the metals. We are not swearing allegiance to the gold bugs camp. Rather, it is a wager on the relationship between two markets. Due to the mean-reverting nature of commodities, we believe that the odds of getting this relative value bet right are much greater than trying to nail the overall trend in precious metals. It’s just smart to play the game where the odds in your favor are the highest.

Recent Extremes

Two weeks ago, the nearest-futures platinum/gold spread closed at -$229.80 (premium gold). This set a new record low. At the same time, the nearest-futures platinum/gold ratio closed at a thirty-year low of 0.8:1. This is the second-lowest ratio in forty-five years of price history. By both measurements, the relationship between platinum and gold is extreme and has reached unsustainable levels.

Platinum Gold spread weekly

Platinum Gold spread weekly

In addition, the platinum/gold spread has been inverted for nine consecutive months now. This is the fourth-longest stretch of time since 1970 that platinum has remained below the gold. If the inversion lasts until Thanksgiving, it will advance in rank to the third-longest consecutive inversion.

However, be mindful of the fact that the second-longest and the longest inversions ran for fourteen months (from late June 1984 through late August 1985) and nineteen months (from mid-September 1981 through April 1983), respectively. There’s no rule that says the spread absolutely must turn right around because of the inversion. But it provides a valuable reference point to set expectations and help us calculate the odds a little bit better.

Platinum Gold ratio weekly

Platinum Gold ratio weekly

The bottom line is that, when we take into account the depth of the platinum/gold inversion (both the spread and the ratio) and the current duration of the inversion (the fourth-longest in nearly half a century of price data), the platinum/gold spread should be setup for a high-probability trade from the long side.

How’d It Get Here?

Platinum and gold have both endured bear markets over the last four years. But after posting a record low of nearly -$200/oz. (premium gold) in 2012, the platinum/gold spread staged a major rally into the middle of 2014 as it rallied $442/oz. (over $44k on a single futures spread!) off the low. While the two metals only rallied for a few months before rolling over again, the spread continued higher for nearly two years as platinum outperformed on a relative basis. That’s a great example of how you can be wrong on the overall direction of the metals and still make a profit by focusing on the spread.

Since the middle of 2014, however, the platinum/gold spread has been spiraling lower with all of the precious and industrial metals. What happened?

Fundamental factors on different continents have caused the metal meltdown. First, there’s China. They have been experiencing the slowest economic growth in decades. China accounts for nearly one-quarter of the world’s demand in platinum, so a slowing economy means less demand for raw materials like metals. Also, the Chinese stock market made a parabolic move into the first half of this year and then crashed. If nothing else, it’s a psychological hit that could dampen growth expectations.

Second, there’s South African production. This country is the world’s largest platinum supplier, accounting for nearly three-quarters of the supply. After workers spent nearly half of 2014 on strike, the issues were resolved and production came back up this year…right at the same time that global demand was slowing. That’s obviously a recipe for lower prices.

Third, the recent Volkswagen emissions scandal tarnished the platinum market. Platinum is used in auto catalysts for diesel engines. Nearly one-third of the world’s supply is used for this purpose. VW’s admission to using test-evading software on diesel cars dealt a serious blow to the diesel car market and, therefore, hammered the platinum market as well.

Finally, the monetary policy here on the home front has also been a contributing factor to lower metals. Expectations that ZIRP is coming to an end as an inevitable rate hike is coming from the Federal Reserve has beat the metals like a rented mule. Market analysts currently only seem to debate the question of “when” and not “if” that’s going to happen.

Light at the End of the Tunnel

There’s a saying on Wall Street that people are the most bearish at the bottom of the market. In regard to the platinum/gold spread, it’s hard to imagine that the news could get even worse. So is this the bottom?

Unfortunately, nobody can tell the future. What we can do, however, is study the past to determine a variety of scenarios for the future and potentially assign probabilities to their occurrence.

The first scenario is that nothing in the current bearish trajectory changes. Things would stay the same or even get worse. China continues to crumble economically, platinum production continues to increase while inventories build, and the Fed hikes interest rates for the first time since the summer of ‘06. That might keep a lid on the platinum/gold spread.

The second scenario is that something actually improves for the metals. This seems more likely since an extremely bearish environment eventually forces a fundamental change somewhere and creates the launching pad for a new bull market. For example, what if platinum miners start to slow production because of dropping profit margins? Although this does not address the demand side of the equation, slowing and/or shrinking supply can certainly be supportive for prices. Or what if the VW scandal is already factored in? This could prove to have been the catalyst for a final capitulation low in the platinum market. If the Fed raises rates 25-basis points could there be a shift in market psychology as investors realize that this is still an historic low level for interest rates? If so, it could allow precious metals to extend their recent rebound.

A third scenario is that a black swan event occurs and causes a major disruption in platinum, gold, or both. Maybe another big mine worker strike in South Africa? How about a military strike that causes gold to surge on safe-haven buying? Or a central bank making a drastic change in the size of their gold reserves? Could we see yet another scandal in the automotive industry? It’s actually impossible to say what the black swan catalyst would be. By definition, a black swan event is one that was not anticipated. The point is that anything could happen (bullish or bearish), so traders and investors better have a plan in place to know how to deal with the market’s reaction when the you-know-what hits the fan.

Multiple Applications

For spread traders, we still advocate taking a long position once the platinum/gold spread makes a two-day close above the declining 75-day Moving Average. This hasn’t happened since the first week of August 2014. Prior bounces this year petered out near the 75-day MA, so a sustained close above it could indicate that the trend has finally turned bullish. This is a classic trend following trade.

For investors, the IMC blog initiated a long position when the platinum/gold spread dropped to -$200.00 (premium gold). The investment is backed with $113k, which was approximately the value of the gold in the spread. This provides any cushion that could possibly be needed to ride out any drawdowns and avoid getting on margin call. We mined several decades of price statistics on this spread, bought near record lows at historically unsustainable levels, and established a long-term position (initially unleveraged) without stops. This is a classic value investment using futures contracts as the instrument of choice.

Stock and ETF Traders

Although the blog focuses on the futures markets, traders and investors can utilize the ETF markets to do the platinum/gold spread as well. Using the gold ETF (GLD) and the platinum ETF (PPLT), a spread position can be created by shorting GLD and purchasing an equal amount of shares of PPLT. Another option is to short GLD and purchase an equal value of PPLT. This would give you more shares of PPLT (since its cheaper than GLD) and weight your position in favor of the platinum side of the spread.

As you can see, the PPLT/GLD spread clipped just below the 2012 prior record low a couple of weeks ago and quickly turned around. This Wash & Rinse signal (a failed bearish breakout) on the weekly chart is indicative of a trend change.

PPLT GLD spread weekly

PPLT GLD spread weekly

It is also very important to note that the charts of the platinum/gold spread in the futures market and the PPLT/GLD spread are identical. Some commodity ETFs have failed at being an accurate proxy for the underlying commodities for various reasons, so it is imperative that you know it before trying to replicate a futures market spread with ETFs. The gold and platinum ETFs pass this test with flying colors.

Using the Spread for Building Bullion Reserves

Another way that knowledge of the platinum/gold spread can be of great value is by using it as timing tool for physical bullion holdings. It can alert investors to times when they should trade their gold in for platinum. Done correctly, this bullion switching can allow an investor to increase their physical holdings for ‘free’ by swapping what is dear for what is cheap. It requires patience, but it is well worth it.

To show how this quantity play works, first recall that the nearest-futures platinum/gold ratio recently plunged to 0.8:1. Stated another way, gold hit a 25% premium over platinum. As the long-term price history shows, platinum normally has the premium over gold. Therefore, we know that gold is currently dear and platinum is cheap. At this level an investor could trade 100 ounces of his gold bullion for 125 ounces of platinum. This will immediately increase the amount of physical bullion he owns by 25%.

The Switch Back

Once the platinum/gold spread goes back to normal and platinum is trading at the premium, the platinum bullion can be traded back in for gold. Because of the premium on platinum, the 125 ounces of platinum will now fetch more than 125 ounces of gold. Just how much more is dependent on where the platinum/gold ratio is at.

A minimum expectation based on history is for platinum to have at least a 15% premium over gold. At that level, the 125 ounces of platinum could purchase nearly 144 ounces of gold. If so, the original size of gold holdings will have increased nearly 44% by simply swapping out at the right times.

Now every few years, the platinum premium balloons to 40% or more. Can you imagine switching your 125 ounces of platinum in for gold with a 40% premium on platinum? This would buy you 175 ounces of gold. If so, the original size of gold holdings will have increased 75% by simply swapping out at the right times. Platinum has not had a 40% premium over gold since the spring of 2010, so it’s probably due within the next couple of years. When you own physical bullion instead of futures contracts that have to be rolled, it’s easier to wait patiently for it to happen.

A bullion investor can also consider scaling out on the way up. For instance, a portion of the platinum can be traded for gold when the premium hits 15%, another portion can be traded in when the premium hits 20%, etc. That way, you are not concerned with trying to nail the very top.

Furthermore, if the investor is on some sort of time schedule that calls for buying more gold bullion periodically, he could have a standing rule to buy platinum in lieu of gold as long as platinum is trading at a discount. This buys more ounces of platinum than gold for the same amount of money. Once again, the platinum would then be swapped out for gold once the inversion is eliminated.

This bullion swapping idea is a bit simplified. It does not include transaction fees, taking a hit on the bid/offer (some dealers mark prices up 20% or more!), etc. However, the theory behind it is that knowledge of the historical boundaries of the platinum/gold ratio can provide investors with high-probability levels to watch for. If it’s timed right, swapping back and forth from platinum to gold can allow an investor to increase their physical bullion inventories without laying out more cash. Now, who doesn’t want free gold?!

In Conclusion

Whether you are a trader or an investor, a leveraged gunslinger or a conservative capital allocator, whether you trade futures and ETFs or buy the physical bullion, one thing is clear: the platinum/gold spread is inverted and is currently priced at historic levels. This presents us with a rare opportunity.

You should be monitoring the situation closely. Time this right and the profit potential is both significant and highly probable. Start working on your plan (entry signals, exit signals, position size, algorithm for adding/decreasing the position, etc.) now so that you can take full advantage of it. Best of luck!

Bean Oil/Corn Spread: The Buy Signal Was Triggered

Bullish Trend Change Signal

On Friday the July 2016 bean oil/corn spread ended the week with a close above the declining 50-day Moving Average for the first time in three and a half months. This triggered an entry signal for the blog, so a hypothetical long position was initiated at -$2,760.50 (premium corn). Initially, we will risk a two-day close below -$4,279 ($200 below the September 15th contract low).

July 2016 Bean Oil Corn spread daily

July 2016 Bean Oil Corn spread daily

We’ve got a couple of things working in our favor here. Fundamentally, the trend change signal occurred after the USDA crop report. For the second month in a row, the government lowered their expectations for the size of the US bean crop. Fewer soybeans usually means less bean oil. Although the corn crop forecast was revised downward as well, it was not quite as much as expected. In addition, the USDA raised their yield estimates for corn. This could have provided a fundamental catalyst for the bean oil to start outperforming corn on a relative basis.

Technically, the close above the 50-day MA shows a shift in the price trend. The last time this occurred, the July 2016 bean oil/corn spread surged to nearly +$1,100 (premium bean oil). Furthermore, the spread made what we call a Wash & Rinse pattern when it cracked support at the mid-July low and then promptly reversed. This failed bearish breakout pattern can often precede significant rallies.

Statistically, the upward reversal has good probabilities of a continuation since it follows a breakdown below -$4k in the spread and a drop to in the ratio to 0.8:1. Both of these levels are historically infrequent and have always been followed by major reversals to the upside.

Minimum Target

Whether or not the trend change signal will work this time is left to be seen. Sometimes it takes a few attempts before the trend change actually sticks. But we do know where the history of where the bean oil/corn spread has gone to after a dip into oversold territory. This allows us to set a target of where we expect this thing to go.

Bean Oil Corn spread weekly

Bean Oil Corn spread weekly

After the bean oil/corn spread hit the second-lowest price of the last four decades in 2012, the spread rebounded to +$3,800 (premium bean oil) over the next two years. This was the lowest rebound level to follow a drop near -$4k or lower. Prior recoveries sent the spread to nearly +$6,900 in 1977, approximately +$5,350 in 1985, and +$4,750 in 1998. Therefore, a minimum target of +$4k seems reasonable.

From another angle, our minimum recovery target for the bean oil/corn ratio is 1.35:1. Looking at the prior instances where the ratio dropped to 0.8:1 or lower, the 2014 recovery to nearly 1.21:1 was the lowest level it reached. Prior recoveries from 0.8:1 or lower pushed the ratio to 1.49:1 in 1974, 1.55:1 in 1977, 1.39:1 in 1985, nearly 1.44:1 in 1988 (the ratio had ‘only’ dropped to just under 0.81:1 prior to that, but it’s close enough to our target to be useful), 1.59:1 in 1998, and 1.48:1 in 2003.

Bean Oil Corn ratio weekly

Bean Oil Corn ratio weekly

These targets are based on the macro timeframe. Don’t expect them to be hit in the next few weeks. History shows that, barring an extreme event like a drought, it takes time to reach these levels. The good news, however, is that it could provide traders with plenty of opportunities to add to long positions as the trend progresses. If we see any interesting setups along the way, we will be sure to let you know.

Bean Oil/Corn Spread: A Buy Setup In the Summer Spread

Grain Market Correlations

The grain markets are highly correlated with each other, some of them even more so than others. In general, the similarities in growing seasons and their usage in food products explain why they normally move together.

There will be times, however, when one particular grain will move substantially more than the other grain markets. It may even buck the trend and go the opposite direction. Such occurrences are usually driven by a specific event. If Russia suspends wheat exports, for instance, the wheat market could soar while the rest of the grains are lackluster. But over time, the grain markets tend to get back in sync with each other and resume their normal relationships.

The mean-reverting nature of the grain markets is why an aberration in a normal relationship can offer trading opportunities. Basically, you want to see a grain spread reach levels that it rarely gets to and then watch the price action in order to time the trend reversal. Perhaps we have a candidate for this scenario right now with the bean oil/corn spread.

Bean Oil and Corn

A strong correlation exists between the bean oil and corn. This makes sense because both markets are used in food products. Bean oil is used in cooking oils and it is also found in salad dressings, mayonnaise, and even margarine. Corn is used as food for us humans and also for animal feed.

Another usage that these two markets have in common is biofuel. As a matter of fact, over one-third of the last US corn crop was used for ethanol production. But whether or not allocating such a big portion of corn supplies for ethanol is a worthwhile endeavor is a whole different discussion. It’s a politically-charged topic, so we’ll avoid it in this particular post.

Bean Oil Corn overlay weekly

Bean Oil Corn overlay weekly

As spread traders, what matters to us is that bean oil and corn have had strong ties for decades. Take a look of how these two markets have trended since 1970. An overwhelming majority of the time, they went in the same direction. Knowing the fundamental link between the two markets and then seeing the history of highly correlated price action to confirm it lays a good foundation that we need for future trading opportunities.

Historic Spread Range

Over the last several decades, the difference between the value of a 60,000 lb. bean oil contract and a 5,000 bushel corn contract has oscillated back and forth in a wide range. As in most spreads, there are a few outliers as well. The bean oil contract seems to have a premium over the corn contract more often than not.

When the bean oil contract premium swells to +$6k or more, things appear to be stretched a bit too far. This has only occurred a little over half a dozen times since 1970. Each time it did, the spread eventually rolled over and retreated until bean oil had surrendered its entire premium.

Bean Oil Corn spread weekly

Bean Oil Corn spread weekly

On the other side of the ledger, the bean oil/corn spread appears to be historically cheap when the value of the bean oil trades at a discount of $4k or more. Such an event has taken place about half a dozen times in the last forty-five years. On the occasions where bean oil traded at a discount of $4k or more, it ultimately turned around and soared until it was trading at a premium of +$3,500 or more over corn.

Smooth It Out With a Ratio

As always, it’s a good ideal to take a peek at the ratio between the markets in the spread that you’re analyzing. The ratio normalizes the relationship. If the markets are priced at record highs or lows the spreads are often trading at historical extremes as well. The ratio will tell you whether or not the relationship between the two markets really is out of whack or not. This isn’t to say that an extreme spread price is not a high-probability setup for a reversal. History shows that it is. But having the same sort of setup in the ratio will increase the odds even more.

The bean oil/corn ratio has spent the last four and a half decades flip-flopping back and forth over 1.1:1 (where bean oil has a 10% premium over corn). The ratio would often stay a year or so above 1.1:1 and then drop back below it. Then the ratio would often stay a year or so below 1.1:1 and then rally back above it. Whichever side of 1.1:1 the ratio is on, you can bet that it’s just a matter of time until it switches sides again.

So perhaps there’s a correlation between this spread and anyone running for office? Is it a coincidence that we expect a reversal during the upcoming election year?! Anyways, let’s get back on topic.

Bean Oil Corn ratio weekly

Bean Oil Corn ratio weekly

When the bean oil/corn ratio is heading either north or south through the 1.1:1 level, we don’t give it much thought. Our interest doesn’t get piqued until the ratio keeps on moving and finally hits an extreme level. Our opportunities are found in the margins.

Heading north, the ratio gets expensive once it reaches 1.4:1. That’s happened a little over a dozen times since 1970. A close at 1.5:1 or higher (basis the nearest-futures weekly chart) is even more intriguing as it has only happened about half a dozen times in the last forty five years. When the ratio reaches this nose-bleed level, it’s a good idea to start looking for a reversal to the downside. Either bean oil is getting ready to spill or corn is about to pop.

When the bean oil/corn ratio heads south, it’s time to start paying attention when it descends to 0.8:1 (where a bean oil contract is worth only 80% of the value of a corn contract). It’s happened just over half a dozen times since 1970. Each event only lasted a few months or even weeks before the ratio recovered and bean oil finally regained its premium over corn.

Here and Now…and Next Summer, Too

We’ve established the fact that the bean oil/corn spread is worth looking at for a buying opportunity once bean oil drops to a discount of $4k or more. We also pointed out that the ratio is a good way to filter things. A ratio of 0.8:1 or lower is a setup for a future recovery. As fate would have it, the bean oil and corn relationship hit both these spread and ratio levels last month.

But wait! There’s more!

July 2016 Bean Oil Corn spread daily (50-day MA)

July 2016 Bean Oil Corn spread daily (50-day MA)

While the December 2015 bean oil/corn spread dropped as low as -$3,500 (premium corn) and the March 2016 bean oil/corn spread dropped as low as -$3,760 (premium corn), it was the July 2016 bean oil/corn spread that closed below -$4k (premium corn) on September 15th. This may be a rare gift from the market gods. Often when a spread or ratio reaches its historical extreme, it is the nearest-futures contracts that do so the most. The deferred contracts are normally priced closer to the mean. Sometimes, the disparity between the nearest-futures spread and the deferred spreads is so wide that it becomes impractical to even consider for a trade. In this case, however, the 2016 summer spread could be the trading opportunity worth pursuing. Thank Ceres for that!

Chart Pattern

Since the contract high was established back in mid-February of 2013, the July 2016 bean oil/corn spread has been stair-stepping lower on the daily timeframe. Each time a prior correction low was broken the spread made a recovery and rallied for several thousand dollars.

The mid-July correction low was breached in mid-September. By the end of the month, the spread had closed back above the mid-July correction low. If the pattern of the last couple of years stays intact, the July 2016 bean oil/corn spread should be in the midst of a run back above the ‘even money’ level where bean oil regains the premium over corn.

Another observation is that the declining 50-day Moving Average has been a level of technical resistance for this spread since the last week of June. That’s when a bearish trend change was triggered via a close below the 50-day MA for the first time since early April. The July 2016 bean oil/corn spread rolled over after it closed in close proximity to the 50-day MA in late July and again at the end of August.

Perhaps a strong close back above the declining 50-day MA (currently around -$2,800) for the first time in three and a half months could indicate that ball is back in the (Chicago?) bull’s court again. If so, spread traders would have a technical reason to get long.

Trade Strategy:

For tracking purposes, the blog will make a hypothetical trade by purchasing one 60,000 lb. July bean oil contract and simultaneously selling one 5,000 bushel July corn contract if the spread closes above the 50-day MA. Initially, the spread will be liquidated on a two-consecutive day close $200 below the contract low that precedes the entry.

Live Cattle/Lean Hog Spread: The Bear Market Rally Could Be Another Short Sale Setup

The Livestock Spread Trade Campaign

On June 25th, the IMC blog initiated a short position in the December live cattle/lean hog spread at approximately 91.85. On September 2nd, an ‘add-on’ position was initiated with another short sale at 78.65. This doubled the position size for three reasons:

First, history indicates that the live cattle/lean hog spread usually returns to the 20-cent area. After this summer’s reversal from the top, the spread has a long ways to go to hit the target. So we want to add to the position as the trend unfolds and squeeze as much as we can out of the move.

Second, the open profit in the initial position was large enough to allow us to double our exposure and risk only a portion of the open profits.

Third, the reward-to-risk expectation for the ‘add-on’ position was either side of 10-to-1. Even if this was an initiating trade instead of an increase in position size the probabilities and the reward-to-risk ratio would still qualify this as an outstanding trade setup.

Another Adding Opportunity

On September 30th the December live cattle/lean hog spread breached price support at the July 16th low. It then recovered quickly and has rallied a little over six and a half cents off the new contract low so far. This temporary support breach and bear market rally has provided us with a setup for another ‘add-on’ position.

December Live Cattle Lean Hog spread daily

December Live Cattle Lean Hog spread daily

During the three-month decline, the spread made two notable bounces. A 520-point bounce off the late June low was followed by a decline to lower corrective lows and a 590-point bounce off the late July low was also followed by a decline to lower corrective lows. Therefore, it would be symmetrically fitting to see the recent rally off the late September low be followed by a break to new contract lows. This is a nice setup for a second ‘add-on’ position.

Big Picture Trading

On the one hand, it can be argued that the live cattle/lean hog spread is very oversold. A quick glance at the daily chart shows that it only took three months to collapse from the contract high to the current contract low.

On the other hand, when we zoom out to a longer timeframe and see where this livestock spread has been over the last forty-five years, it appears that the bearish trend change off this year’s record high may just be the beginning of a major decline. The new bear market is just a cub!

Live Cattle Lean Hog spread weekly

Live Cattle Lean Hog spread weekly

The current contract low for the December live cattle/lean hog spread is 64.20. This is more than triple the median spread price (our minimum expected objective) of 20 cents. As you can readily see on the charts, last year is the first time in nearly half a century of price data that the spread has ever been as high as 64.20 (the red dashed line). Therefore, a break to new contract lows in the December spread could keep the spread in freefall mode. It seems like a good opportunity to increase the position size again by adding another spread if the breakdown continues.

Trade Strategy:

The blog will work a hypothetical ‘add-on’ order to sell one 40,000 lb. December live cattle contract and simultaneously buy one 40,000 lb. December lean hog contract if the spread closes below 64.20 (premium cattle). Initially, risk this ‘add-on’ position to a two-day close .50 points above the October high that precedes the entry.

Soy Meal/Bean Oil Spread: A Failed Summer Bullish Breakout Attempt and a Bearish Breakdown Last Week. Is This the Start Of an Overdue Bear Market?!

The Soy Meal/Bean Oil Flip-Flop

At the midpoint of 2015, the IMC blog initiated a reversal strategy in the December soy meal/bean oil spread. The idea behind the strategy is that a breakout to new contract highs could clear the way for the spread return to the 2014 summer high of +$24,726 (basis the weekly nearest-futures) or else it should finally roll over and return to the ‘even money’ level. Either way, a move of several thousand dollars is expected.

The strategy calls for always being short on a close below +$13,500 and always being long on a close above +$15,500. So far, we’ve been whipsawed. The blog shorted the December soy meal/bean oil spread at approximately +$13,664 on June 30th, reversed and went long at +$15,818 on July 15th, and once again reversed and went short at +$13,284 on October 2nd. After taking two losses in a row, we hope that this third time will be the charm.

December Soy Meal Bean Oil spread daily

December Soy Meal Bean Oil spread daily

Technically, we have a couple of things in favor of the new short position. First of all, the December soy meal/bean oil spread broke out into new contract highs back in July. After no follow-through and a couple of months in a trading range, the recent decline is indicative of a failed breakout attempt.

Secondly, the spread closed below the August 12th correction low last week. This was the lower boundary of the trading range. This pattern is considered a bearish breakout.

Review the Big Picture

When we step back and look at where the soy meal/bean oil spread has been over the last 45 years, it gives us a clear indication that the current price is both an infrequent and expensive occurrence. Previous excursions to these highs have been followed by a return to ‘even money’ where the soy meal surrenders its entire premium.

Soy Meal Bean Oil spread monthly

Soy Meal Bean Oil spread monthly

After two years at the high end of the price range, it seems that a reversion is due. Let’s see if the recent price break is the start of it. If not, we will not fight the price. A breakout to new contract highs would be a bullish event and give us a good reason to get back on the long side of the soy meal/bean oil spread.

Slight Parameter Change

Due to an increase in volatility and the July, August, and September price peak levels for the December soy meal/bean oil spread, we think it would be prudent to raise the level for the buy side of the reversal system.

The spread peaked at +$15,890 in July, +$15,842 in August, and +$15,744 in September. Therefore, buying a close above +$15,500 would be inside the recent trading range. We are going to raise the buy level $500 to account for this.

Trade Strategy:

The blog is holding a hypothetical short position in the December soy meal/bean oil spread that was entered at approximately +$13,284 on October 2nd.

Continue to run the reversal system to initiate a long position (long meal and short oil) on a close above +$16k and a short position (short meal and long oil) on a close below +$13,500. Each price level will act as a stop and reverse point.