Corn/Oat Spread: Sell the Bounce!

Another Day, Another Grain Spread Play

Wow, we’ve made a ton of posts on various grain spreads recently!  The big run over the last couple of months has pushed some spreads into historically high territory where the ground was fertile for prior bear markets to be sown.

Another grain spread that may be ready for short sellers to harvest is corn vs. oats.  Let’s take a look and see why.

First of all, the correlation between corn and oat prices has been very strong for the last several decades.  I bet if I had the cash prices for the last hundred years readily available it would show the same thing.

Corn Oats overlay weekly

Corn Oats overlay weekly

For the IMC blog, a strong correlation between two markets is the first order of business in hunting for spread trading opportunities.  Remember, we look for commodity spreads that hit historic extremes (hitting multi-year highs, outliers, pushing past two standard deviations, etc.) and then bet on a reversion to the mean.  So a strong correlation is a necessary foundation for this strategy to work.  And the corn and oat markets have it!

The Ratio Says It All

A few weeks ago, the corn/oat ratio ended the week at 2.22:1 and nearly matched the January 2012 multi-year high of 2.24:1.  At this level, the price of corn is more than double the price of oats.

Corn Oats ratio weekly

Corn Oats ratio weekly

A ratio of 2.2:1 is historically very expensive.  Over the last forty-five years, the corn/oat ratio has made it to 2.2:1 or higher not even a dozen times.  Each occurrence has been followed by a major bear market decline.  There’s no reason to think this pattern will stop now.

Every prior run to 2.2:1 or higher has been followed by a decline to 1.45:1 or lower.  Therefore, once the ratio shows that the trend has reversed and turned bearish, 1.45:1 should be our minimum downside target.

The Spread

Since corn is double the price of oats, we will normalize the spread relationship by trading one corn contract against two oat contracts.

Three weeks ago, the corn/oat (x2) spread had closed a nearly four-year high of +42 1/4 cents (premium corn) on the weekly nearest-futures chart.  This is only the fifth bull market since 1970 that has reached +40 cents (premium corn) or higher, basis weekly nearest-futures chart.  It certainly qualifies as an extreme.

Corn Oats (x2) spread weekly

Corn Oats (x2) spread weekly

The bear markets that followed the prior four bull markets sent the corn/oat (x2) spread down to final lows of -$1.15 3/4 (premium oats) in 1977, -$3.83 1/2 (premium oats) in 1988, -85 1/4 cents (premium oats) in 1997, and -$5.63 1/2 (premium oats) in 2014.

Basis a futures spread position consisting of one short corn contract and two long oat contracts, the size of the bear market declines from the highs to the lows were $8,737.50 into the 1977 bottom, $21,212.50 into the 1988 bottom, $7,100 into the 1997 bottom, and $31,625 into the 2014 bottom.  This indicates to us that the bear markets in this spread are worth trading!

The September Spread

The September corn/oat (x2) spread surpassed the ‘even money’ mark on May 25th.  The current contract high of +18 1/4 cents (premium corn) was made three weeks ago on June 3rd, which is the same day that the nearest-futures July spread posted its multi-year high of +42 1/4 cents (premium corn).

The nearest-futures July spread has collapsed over the last three weeks.  Today it touched an intraday four-month low of -40 cents (premium oats).  The September spread is moving at a slower pace as it has only pulled back to a six-week low.  Given the size of the selloff, a bear market bounce would not be all that surprising.

September Corn Oats (x2) spread daily

September Corn Oats (x2) spread daily

For the first time in a month, the September corn/oat (x2) spread has spent an entire week below the ‘even money’ mark.  Therefore, this level is now an important psychological barrier.  Furthermore, a Fibonacci .618 retracement of the current decline sets technical resistance just beyond this psychological level at +2 1/4 cents (premium corn).

Based on the idea that the current break is a bit stretched and due for a bounce…

And that the ‘even money’ mark will offer psychological resistance…

And that a Fibonacci .618 resistance line is located just a couple of pennies above it…

The blog’s initial strategy will be to short the September corn/oat (x2) spread on a bounce to ‘even money’ and risk to new contract highs.  Once we have a decent size open profit on the initial position we will look for a setup to start pyramiding it.

Trade Strategy:

The blog will work a hypothetical order to sell one 5,000 bushel September corn contract and simultaneously buy two 5,000 bushel September oat contracts at ‘even money’.  If filled, exit on a two-day close above +20 cents (premium corn).

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