Grain Basket: Roll to the Summer Spreads

Stay Short

The IMC blog entered a short position in 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) at +$2.16 (premium beans) on February 13th.

With the upcoming First Notice Day for the May grain contracts, we are going to roll to the July contracts.

July Grain Basket spread daily

July Grain Basket spread daily

After cracking support at the rising 100-day Moving Average in February, the Grain Basket slumped to multi-month lows.  It has rebounded over the last couple of weeks, but the now declining 100-day MA should provide technical resistance and cap the rally.

The April 11th multi-month low of $1.29 1/2 sets near-term price support.  A break below this price should clear the way for a collision with the psychological one dollar mark.  If the July Grain Basket does hit a new low for 2017 the blog will be watching closely to see if a setup materializes that would allow for an additional ‘add-on’ short sale to take advantage of the continued descent.

Trade Strategy:

Exit the short May soybean contract, long May wheat contract, and long May corn contract and simultaneously sell  short a short July soybean contract, buy a July wheat contract, and buy a July corn contract at the market-on-close on Tuesday, April 25th.  Risk the July grain basket spread to a two-day close above +$2.80. 

 

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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

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

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. 

Grain Basket Spread: Out With a Profit

The Basket is Now Empty

On July 14th, we initiated a hypothetical long position in the Nov-Dec 2016 Grain Basket spread by purchasing one long November 2016 soybean contract and then shorting one December 2016 wheat contract and shorting one December 2016 corn contract at a price of approximately -61 1/2 cents (premium the sum of the wheat and corn).

Today we liquidated the position at a price of approximately -23 cents (premium the sum of the wheat and corn). This resulted in a profit of approximately +$1,925 per spread, not including commissions.

Nov-Dec 2016 Grain Basket spread dailyThe narrowing range of the last few months caused us to lower our exit target to a close at -30 cents or higher. This was triggered today. Now we are going to cool our heels on this spread for a while. To get us interested in a new position, the Nov-Dec 2016 Grain Basket spread or the July 2017 Grain Basket spread will have to drop to at least -$1.00 (premium the sum of the wheat and corn) or rocket to at least +$1.50 (premium beans). If that happens, we will start forming a game plan. Until then…

Grain Basket Spread: Change the Profit Target

The Grain Basket Spread

The blog initiated a hypothetical long position in the Nov-Dec 2016 Grain Basket spread on July 14th. The position consists of one long November 2016 soybean contract, one short December 2016 wheat contract, and one short one December 2016 corn contract.

The position was entered at approximately -61 1/2 cents (premium the sum of the wheat and corn). For the last few months, we have had a standing order to exit on a close at ‘even money’ or higher. This was due to the spreads previous excursions to where beans gained the premium over wheat and corn for a few days before it rolled right back over.

When Things Change, Be Flexible

Our standing target has not yet been hit. Since Memorial Day, the Nov-Dec 2016 Grain Basket spread has peaked just above -30 cents (premium the sum of the wheat and corn) several times and then rolled over. We have to acknowledge that this is working as a resistance area.

Nov-Dec 2016 Grain Basket spread daily

Nov-Dec 2016 Grain Basket spread daily

Furthermore, we initially bought the ‘red’ new crop Grain Basket spread when it was trading at a substantial price discount to the nearest-futures spread. The difference between the nearest-futures Grain Basket spread and the Nov-Dec 2016 Grain Basket spread has narrowed quite a bit since the summer. This gave away some of our edge. Therefore, we think it might be prudent to lower our target and look for a smaller profit.

Trade Strategy:

On the long position in the Nov-Dec 2016 Grain Basket spread entered at approximately -61 1/2 cents (premium the sum of the wheat and corn), exit on a close at -30 cents or higher instead of waiting for parity.

Grain Basket Spread: Let’s Set a Profit Target

The Grain Basket Spread

On July 14th a hypothetical long position was initiated in the Nov-Dec 2016 Grain Basket spread (long one November 2016 soybean, short one December 2016 wheat, and short one December 2016 corn) at approximately -61 1/2 cents (premium the sum of the wheat and corn).

We bought this distant month spread because of its unusually steep discount to the nearest-futures spread and also because it was approaching a level that is historically cheap.

At the beginning of the month, the beans were priced at a discount of one dollar to the sum of the wheat and the corn. On the nearest-futures monthly chart, whenever this Grain Basket spread dropped to a discount of one dollar or more and reversed, it ultimately inverted and went back up to a premium of +$1.50 (premium beans) or more.

Like a Broken Record

The problem is, the nearest-futures Grain Basket spread has not been inverted for over two years. It appears to be a distant-month contract anomaly. Therefore, we are going to shorten our timeframe a bit and put a profit target on the current position.

Over the last year, it appears that the Nov-Dec 2016 Grain Basket spread has had a hard time keeping its head above the ‘even money’ mark:

-After reaching a premium of +12 cents last July, the spread rolled over and dropped nearly 56 cents in a month.

-By late September the spread was a half-cent away from the July top. It didn’t last long. The spread dropped 61-cents over the next four weeks.

Nov-Dec 2016 Grain Basket spread daily

Nov-Dec 2016 Grain Basket spread daily

-On November 11th the Nov-Dec 2016 Grain Basket spread spiked to a new multi-month high of +14 1/4 cents (premium beans). Was this finally a bullish breakout?! Nope. Three weeks later, it had dropped to a new multi-month low as it lost 87-cents.

-The next time the spread cleared the ‘even money’ mark was in late February. It lasted two days. One month later, the spread had declined 70 cents from the peak.

-On April 27th we saw a one-day close above ‘even money’ and then a pullback for the rest of the week. On Cinco de Mayo, there was one more close above ‘even money’ when November 2016 soybeans gained a two-cent premium over the sum of the December 2016 wheat and December 2016 corn. From this top, it began a nearly two-month decline and posted a new contract low of -$1.02 3/4 on the last day of June.

If You Can’t Beat ‘Em…

Based on the behavior pattern of the last year, it seems that the logical thing to do is exit a long position if the Nov-Dec 2016 Grain Basket spread closes at ‘even money’ or higher. We can then look for a reentry if it drops back to a discount of half a dollar or more. If Murphy’s Law comes into play and the spread finally makes a breakout and never looks back…well, at least we got a little piece of the action and bagged another profit. We’ll simply take the winnings and go shopping for some new bargains elsewhere.

Trade Strategy:

On the long position in the Nov-Dec 2016 Grain Basket spread entered at approximately -61 1/2 cents (premium the sum of the wheat and corn), exit on a close at ‘even money’ or higher.