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.
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.
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.
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.
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!
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.
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.
The 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.
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.