Cocoa/Sugar Spread: Roll to May Contracts

The Bear Continues

The IMC blog has been on a short sale campaign in the cocoa/sugar spread for nearly seventeen months.  Thanks to the initial position and some ‘add-ons’ we picked up, the blog is short a March cocoa/sugar spread from the equivalent of +$21,866 (premium cocoa), short a second March cocoa/sugar spread from the equivalent of +$18,509.80 (premium cocoa), short a third March cocoa/sugar spread from the equivalent of +$15,300.40 (premium cocoa), and short a fourth March cocoa/sugar spread from the equivalent of +$1,550.40 (premium cocoa).

The bear market remains in full force, so we will remain short.  Currently, it will take a two-consecutive day close above the declining 100-day Moving Average to tell us that the trend has changed and prompt us to take the money and run.  That hasn’t happened since last April.


Cocoa Sugar spread (nearest-futures) daily

Furthermore, we are waiting to see what happens if/when the spread drops to -$4,000 (premium sugar).  Prior bear markets in the cocoa/sugar spread ended after this level was reached and set the stage for bull markets.  That means we will start thinking about trading the long side of the cocoa/sugar spread if it makes down to this area.

Trade Strategy:

On the four March cocoa/sugar spreads entered at the equivalents of +$21,866, +$18,509.80, +$15,300.40, and +$1,550.40 (premium cocoa), roll to the May spreads at the market-on-close on Friday, February 24th.  Risk all four spreads to a two-consecutive day close above the declining 100-day Moving Average, basis the nearest-futures.  


T-bond/T-note Spread: Roll to the June Contracts

Waiting For the Next Shoe to Drop

The IMC blog initiated a short position in the March T-bond/T-note spread at 26-18 (premium bonds) on January 20th.  For the last month, we’ve had little to show for our efforts as the spread has remained range-bound.

However, the spread did flash a major bearish signal back in early October when it closed below the widely-watch 200-day Moving Average for the first time since the first week of 2016.  We felt that the right move was to get short once the rally off the December low started to fade.  We still think that.


T-bond T-note spread (50 and 200 MAs) daily

A breakout above the current trading range would be our signal to take a loss on this initial trade and get to the sidelines.  If that occurs, it would increase the possibility of a rally to resistance at the declining 200-day MA where we would watch for a setup to take another crack at it.  Until then, we simply stay short.

First Notice Day for the March treasury contracts is on Monday.  Therefore, we have to roll to the June contracts today in order to maintain our position.

Trade Strategy:

Liquidate the short March T-bond/T-note spread and simultaneously enter a short June T-bond/T-note spread at the market-on-close on Friday, February 24th.  Risk the June spread to a two-day close above 27-24.  

Feeder/Corn Spread: Time to Rollover

Staying the Course

The IMC blog is holding a short position in the March feeder/corn (x4) spread from the equivalent of -$8,487.50 (premium corn).  We’ve been in this position since September 6th and patiently rolling over.  It’s time to do it again.

The spread will be rolled to the April and May contracts.  Based on the current prices, this will end up readjusting our equivalent entry level to somewhere around -$9,700 (premium corn).


Feeders Corn (x4) spread weekly

So is it worthwhile to stay short?  We think so.  As you can see on the weekly timeframe, near-term support is located at last year’s low of -$18,837.50 (premium corn).  A clean break below this level could clear the way for a decline to the 2012 high of -$31,612.50.  Remember the technical charting rule: Old price resistance, once it has been broken, becomes new price support.

Trade Strategy:

Buy back the short 50,000 lb. March feeder cattle contract and simultaneously sell short an April feeder cattle contract at the market-on-close on Friday, February 24th.  Also, sell the four 5,000 bushel March corn contracts and simultaneously buy four 5,000 bushel May corn contracts at the market-on-close on Friday, February 24th.  Risk the April-May feeder/corn (x4) spread to a two-day close above even money.


Copper/Crude Spread: Rollover Update

Overdue Update  

The IMC blog entered a short position in the March copper/crude oil spread at +$13,265 (premium copper) on December 1st.  We rolled to the May contracts at the market-on-close last Friday (February 17th) because Monday was the Last Trading Day for the crude contract.

Alas, I had a blog post all queued up for the rollover last Friday and forgot to send it!  If you have a decent broker, however, they should have given you notice that the March crude contract needed to be liquidated or rolled.

On February 17th, the March copper/crude oil spread closed at +$14,275 and the May copper/crude oil spread closed at +$13,880.  Therefore, the discounted price would put us in the May spread at the equivalent of +$12,870.


May Copper Crude Oil spread daily

As a reminder to why the blog initiated a short position, it is because the nearest-futures copper/crude oil spread signaled a bearish trend change after peaking out at +$20,640 in late November.  Historically, prior runs to +$17,000 or higher have been followed by major bear markets that hammered the copper/crude oil spread down to where crude oil had a premium of $10,000 or more over the copper.  Therefore, this could be just the start of a major decline.  We will be watching for setups to add to the short position along the way.

Copper/Gold Spread: Stay Long For More Upside

Keep ‘Em Rollin’

Currently, the blog is holding a long position in the March-February copper(x2)/gold spread from the equivalent of -$22,700 (premium gold).  It was entered on September 29th.

We’re still happy with the position.  But with the February gold contract expiring on Friday and the First Notice Day for the March copper contract hitting next Tuesday, it’s time to roll out into the later contracts.  Since the summer spread (July-June) is only about $300 more than the spring spread (May-April), we’re going to opt for more time and hop into the summer spread.

Since peaking out just above +$17k (premium copper) on December 5th, the July-June copper(x2)/gold spread has been stuck in a trading range.  The spread clipped the December 5th high last week, but has retreated once again.  What we need to see is a sustained close above the early December/mid-February high to get the momentum going again.  If that happens, the spread will stay on track for a run to the resistance zone between the 2015 high of +$28,190 (premium copper) and the November 2014 high of +$34,380 (premium copper).


July June Copper Gold spread daily

But remember that we mentioned before that the ratio between copper and gold (currently around 0.56:1) indicates that the spread could go substantially higher than the 2014/2015 price peaks!  Historically, prior occurrences where two copper contracts traded equal to or at a discount to the value of one gold contract were followed by major bull markets.  Each one lasted until two copper contracts were valued at a minimum premium of 66% over the value of one gold contract.  That puts the ratio at 1.66:1.

To hit this minimum ratio target of 1.66:1, the copper(x2)/gold spread would have to soar to somewhere between roughly +$53k (if the current copper price remained the same) and roughly +$78k (if the current gold price remained the same).

Based on this history, we are watching the spread carefully to see if a setup materializes to add to the long position after a breakout above the current trading range.  We’ll keep you posted if that happens.  For now, though, let’s roll out to the summer contracts.

Trade Strategy:

Sell the two March copper contracts and simultaneously buy two July copper contracts at the market-on-close on Wednesday, February 22nd.  Also, buy back the one short February gold contract and simultaneously sell one June gold contract at the market-on-close on Wednesday, February 22nd.


Sugar/Corn Spread: Strap In For the Next Bear Market

Early Stage Bear Market

The spread between sugar and corn may have ended a four-year bull market right when Q4 started last year.  If so, historical precedent suggests that it could now be at the very start of a multi-year decline.  That means there should be plenty of opportunity, both in terms of time and price, to take advantage of it.  Spread traders would be wise to start paying attention to this one.

To even consider a potential spread trade, though, the IMC blog first likes to establish that the markets in question have historically exhibited a strong correlation.  It can’t be just a short-term fluke.

In the past, there have been strange anomaly periods where markets with no fundamental relationship (like soybeans and silver, for example) were somehow highly-correlated for a few months.  But that certainly doesn’t mean that it’s got the makings of a good spread trade candidate.

There have also been market crisis situations where markets that are normally unrelated all go to a correlation of one.  Remember the crash of ’87 or the Great Financial Crisis of ’08?  The temporary strong correlation of all markets was the product of a liquidity crisis and dissipated once the crisis has passed.

Therefore, we want to see decades of price history where a couple of markets have shown correlation.

Cousins, Not Twins

Go back the last thirty-five years on a weekly closing-basis, and you will see that the prices of sugar and corn are pretty correlated.  This is likely due to the fact that both markets are used as derivatives to produce ethanol.  Also, sugar and corn syrup are both used as sweeteners in food products.

Now, you’ll also notice that the correlation would strengthen and weaken.  This ebb and flow of correlation is because the crops have some different uses, different main production areas, and several other fundamental differences that can impact one crop without directly impacting the other.  So they may not look exactly like identical twins when you compare the charts, but they at least look related enough to be first cousins!


Sugar Corn overlay (nearest-futures) weekly

Despite the inconsistency in the correlation periods –heck, maybe even because of it- the spread between sugar and corn has offered some great trading opportunities.  This often was the case after one market had outperformed the other for a prolonged period of time or when there was a temporary disconnect where one market was trending while the other was static or even trending in the opposite direction.  Eventually, this divergence would end and a major price reversal in the spread would occur.

Historical Price Boundaries

A sugar futures contract controls 112,000 pounds of sugar and a corn futures contract controls 5,000 bushels of corn.  So the blog converts the contracts to their market value before plotting a spread in order to simplify and clarify things.

About four months ago, the nearest-futures sugar contract was worth almost +$9,300 more a nearest-futures corn contract.  Not only was this significant by being the highest premium in over six and a half years, but it was also only the fourth time in the last four decades that a sugar contract has ever reached a premium of +$9k or more over a corn contract.  The prior three occurrences were followed my multi-year bear markets.  Therefore, it would not be surprising if a major decline was on the horizon.

sugar-corn-spread-nearest-futures-weeklyFor how long?  And, more importantly, how big?!

Consider the prior three bear markets that started above the +$9k mark:

The bear market that started from the October 1980 top lasted three years and nine months.  The decline from top to bottom was approximately $44,300.

The bear market that started from the January 2006 top lasted two years and six months.  The decline from top to bottom was approximately $35,300.

The bear market that started from the January 2010 top lasted two years and seven months.  The decline from top to bottom was approximately $33,800.

The sugar/corn spread seems to act like a pendulum.  After reaching an extreme on the high side, the bear markets that followed these three peaks crushed the spread to levels rarely seen on the downside.  You can see that there have only been a few instances where the sugar contract value traded at a discount of -$12k or more to the value of a corn contract.  Down at those levels, the spread always turned out to be a great buying opportunity again!

This price history certainly does not guarantee that the sugar/corn spread will drop tens of thousands of dollars over the next two or three years.  But it does show us what occurred before, which tells us the potential and the probabilities of what could occur.

The Ratio Test

As always, we like to look at the ratio between the markets as well.  This helps normalize the prices.  It’s a filter that tells us if the market relationship really is truly at an extreme level by historical standards.

In early October the nearest-futures sugar/corn ratio peaked at 1.54:1.  So the value of a sugar contract was worth 54% more than the value of a corn contract.  Looking at the weekly price data of the last forty years, this was only the fifth bull market that pushed the ratio to 1.5:1 or higher.  Therefore, the ratio confirms what the spread is telling us: Sugar is just way to expensive in comparison to corn.


Sugar Corn ratio (nearest-futures) weekly

On the other side of the coin, sugar is historically too cheap in comparison to corn when the ratio drops to 0.5:1 or lower.  At that point, one sugar contract is worth only half as much as a corn contract.  That hasn’t happened since the financial crisis.

The Price Action

Over the last two and a half years, the 150-day Moving Average has been a reliable trend indicator for the nearest-futures sugar/corn spread.  When the spread closed below the 150-day MA at the end of November 2014 it continued its descent until August of 2015.

After a failed breakout above the 150-day MA in the first part of September 2015, the spread made a second attempt at the end of the month and was successful.  This launched a runaway move that lasted for about a year.


Sugar Corn spread (nearest-futures) daily

Now, I do want to point out that two failed bearish trend change signals occurred in February and April of 2016.  However, both signals were reversed within a couple of days.

Two months ago, the nearest-futures sugar/corn spread made a clean break below the 150-day MA.  It has stayed below it the whole time since.  Therefore, a trend follower would have to consider the spread to be in a bearish trend at the moment.

Zeroing In

On the nearest-futures chart, the sugar/corn spread rallied off the December low and has been stuck in consolidation mode for the last month.  The spread scraped against resistance at the 150-day MA.  If it starts to roll over here, a second leg down could commence.

Looking at the May sugar/corn spread specifically, we can speed things up a bit and measure the trend according to the 50-day Moving Average.  When this spread cracked the 50-day MA in October it signaled a bearish trend change.  The spread then closed back above the 50-day MA again once the New Year began and turned bullish.

Interestingly, the uptrend did not continue after the January trend change signal.  The May sugar/corn spread has been stuck in a sideways trading range.  A break below the January low and close back under the 50-day MA would put the ball back in the bear’s court.


May Sugar Corn spread daily

Let’s put this all in context.  The fact that the nearest-futures spread peaked last year at levels that have previously led to major bear markets…

The fact that the sugar/corn ratio also reached historic extremes that have always been unsustainable…

The fact that the spread is still in a downtrend on the nearest-futures chart by virtue of the fact that it remains below the 150-day MA…

One would have to think that selling the May sugar/corn spread on a close below the 50-day MA would be a trade worth taking!

Trade Strategy:

Place a hypothetical contingency order to sell one 112,000 lb. May sugar contract and simultaneously buy one 5,000 bushel May corn contract if the spread closes below the 50-day MA (currently around +$3,666).  If filled, liquidate the position on a two-consecutive day close $500 above the 2017 high that precedes the entry (currently at +$4,923.90). 

Cattle/Hog Spread: Roll to the April Contracts

When Pigs Trump Cows

On October 12th the blog initiated a theoretical short position in the livestock markets by selling one February live cattle contract at 99.525 and simultaneously buying two February lean hog contracts at 50.925.  This positioned us in the spread at a price of -2.325 cents as the sum of the price of two hog contracts was worth about two and one-third of a cent more than the price of one cattle contract.

We got into the position when the ratio was just below 2:1.  As you recall from an earlier post, there were only about half a dozen times in the last few decades where the cow/pig ratio made it as high as 2:1 or more.  Therefore, we figured a short sale after peaking above 2:1 would put the historical odds in our favor as we bet that the hog market would start to outperform the cattle market.

Still Going

Yesterday the February cattle/hog ratio closed at a low of 1.63:1, matching the contract low set back in June.  Things are going well!  The problem is that the February contracts go off the board in a few days.  That means we have to book the trade or roll over.

So what to do?

First of all, consider the fact that all but one of the declines that started from a peak of 2:1 or higher took the ratio below 1.1:1.  The one exception still took the ratio below 1.4:1.  Therefore, history implies that the bear market is not close to finished yet.  So it makes sense to stay short as long as the downtrend is still intact.


Live Cattle Lean Hog ratio (nearest-futures) monthly

Secondly, we have to consider the rollover costs.  The April cow/pig ratio closed at a multi-month low of 1.62:1 yesterday and the June cow/pig ratio closed at a multi-month low of 1.34:1.  That April ratio is similar to the closing price of the February ratio of 1.63:1, but the June ratio is significantly below the closing price of the February ratio.  Based on this, it makes sense to roll to the April spread to get a couple more months of time out of the trade, but it does not make sense to think about switching to the June spread yet.

Trade Strategy:

On the hypothetical short February live cattle/lean hog (x2) spread entered at -2.325 (premium hogs), roll to the April contracts at the market-on-close on Tuesday, February 7th.

Grain Basket Spread: Is the Bear Coming Out of Hibernation?

The Grain Basket Spread

I’ve traded the spread between soybeans and the sum of wheat and corn for many years and I’ve also posted about it on this blog a few times.  I nicknamed this spread the grain basket.  And sometimes it has been known to make baskets of money!  Based on current conditions, it appears that the grain basket spread may be shaping up for a new trading opportunity.

Price Correlation

Historically, the price relationship between soybeans, wheat, and corn has mostly been a highly-correlated affair.  Notice the word “mostly.”  There have been times when the correlation seemed to weaken.

For instance, we’ve seen a drought in Russia scorch the wheat crops and send wheat prices rocketing while it had no effect on world prices of beans and corn.  There have also been major hits to the South American bean crop that sent US soybeans to the moon, while corn was up modestly and wheat did nothing.


Soybeans Wheat Corn overlay (nearest-futures) monthly

These divergent moves produced a drop in correlation, but they have always proved to be temporary events.  Over the long haul, the three grains have always gotten back in sync.  That’s what makes them such an attractive candidate for spread trades.

Historical Boundaries

As readers know, the IMC blog only takes an interest in the spreads that are at historical extremes.  Due to the mean-reverting nature of commodities, we believe that a spread trading at an historical extreme has a high-probability of making a sizable reversal and is worth betting on.  The trick, of course, is timing that reversal.

So what constitutes as an historical extreme?  Good question.  Here’s my way of looking at it.

Initially, a spread that has moved more than two standard deviations from the mean is a good candidate.  Remember, roughly 95% of all data values in a data distribution fall within two standard deviations from the mean.  So once a spread gets past the two standard deviation signpost, it’s stretched pretty thin.

Now, if you want to break it down into even simpler terms and shoot for a less technical answer, how about this: a spread is considered to be trading at an historical extreme when it reaches a price level that has only been reached infrequently (if ever) and has never been a sustainable level.

Using the grain basket spread as our example, take a look at nearly half a century of monthly price history.  Notice that there have only been a total of six bull markets that ran the spread up to three dollars or higher (premium beans).  Also, the longest consecutive run of month-end closes at three dollars or higher was four months.  Therefore, we can consider the spread to be “expensive” and at an historical extreme when beans command a premium of $3-per-bushel over the sum of wheat and corn.


Grain Basket spread (nearest-futures) monthly

Conversely, we can consider the grain basket spread to be “dirt cheap” and at an historical extreme when the sum of wheat and corn gain the upper hand and trade at a premium of two dollars or more over the price of soybeans.  Only three bear markets in the last fifty years have brought the spread to levels that low!

Grain Expectations

First off, let’s establish this basic and very important fact: It is absolutely impossible to know with certainly what the future will be.  Otherwise, palm readers and tarot card shops would not be located on the sketchy side of town.  And people who use Ouija boards and Magic 8 Balls would have their own yachts.

But what we can know is what the outcome probabilities are for future events.

There is a very important difference here.

That being said, notice that all six of the bull markets that ran the grain basket spread to three dollars or higher (premium beans) were followed by bear markets that erased the entire premium from the beans.

Therefore, a trader who gets positioned on the short side of the grain basket spread after a reversal signal occurs at $3-per-bushel or higher should be targeting a return to ‘even money’ or lower.  This will help you assess the reward-to-risk ratio on your trade setups and pyramid positions.

The Improbable Still Happens

Although I just picked on the fortune tellers for trying to divine the future, it does not mean that people like us who focus on the probabilities are completely off the hook.  Some people tend to forget that probabilities are not guarantees.  The improbable still happens!  And sometimes more often than we’d like to think.

Consider the Chicago Cubs winning the World Series last year or the Patriots coming back to win the Super Bowl in overtime last night…

Or the Brexit vote last summer or Trump’s election victory three months ago!

This is why you have to learn to bet according to the probabilities to become a good trader, but then you have to learn to manage risk according to the possibilities to become a great trader.

Current Outlook

The May grain basket spread (the difference between the price of one May soybean contract and the sum of one May wheat contract and one May corn contract) broke out of a multi-month trading range at the end of 2015 and has been trending higher since then.

During this bull run, the spread stayed above technical support at the rising 100-day Moving Average…until a month ago when it made a two-day close below the 100-day MA for the first time in over a year.

may-grain-basket-spread-dailyThe spread quickly rebounded and recovered nearly three-quarters of the pullback from the December peak.  However, prices softened over the last couple of weeks and the 100-day MA is being tested once again.

If the mid-January bounce turns out to be a secondary (lower) high and the May grain basket spread closes back under the 100-day MA, it may be time to start betting that the bull market is over.

Trade Strategy:

For tracking purposes, the blog will make a hypothetical trade by selling one 5,000 bushel May soybean contract and simultaneously buying one 5,000 bushel May wheat contract and buying one 5,000 bushel May corn contract if the spread between soybeans and the sum of the wheat and corn closes below the rising 100-day Moving Average (currently at +$2.22 1/4).  If filled, risk a two-day close of 5 cents above the contract high that precedes the entry. 

Minneapolis/KC Wheat Spread: Trade Parameter Revision

Making a Play For May

The IMC blog has been working an order to short the March Minneapolis/Kansas City wheat spread.  Since the March grain contracts will have their First Notice Day in just another three weeks, however, it may be a prudent time to shift our focus over to the May spread.


May Minneapolis Kansas City wheat spread daily

Over the past year, the May spread has made several pullbacks during the overall run higher.  Each pullback bottomed out above the rising 100-day Moving Average.  Therefore, we are going to keep things simple and use a close below the 100-day MA as a green light to go short.

Trade Strategy:

Cancel the hypothetical order to short the March Minneapolis/Kansas City wheat spread.  Place a new order sell one May Minneapolis wheat contract and simultaneously buy one May Kansas City wheat contract if the spread closes below the rising 100-day MA (currently at +96 1/2 cents).  If filled, risk a two-day close of three cents above the spread contract high that precedes the entry (currently at +$1.25 3/4 cents).