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. 

Soy Meal/Soybean Spread: Book the Profits!

All Good Things…

Must come to an end!  This includes profitable market trends as well.

The IMC blog stalked the Dec-Nov soy meal (x2)/soybean spread for a short sale setup last summer after it reached historically unsustainable highs.  The short sale campaign was finally initiated in late June when the spread closed below the rising 30-day Moving Average for the first time in two and a half months.

As the downtrend unfolded, the position was pyramided a couple of more times when we sold more spreads short at the start of August and even more at the end of August.

This put us in an initial short position at +$21,125 (premium meal), a second ‘add-on’ position at +$17,690, and a third and final ‘add-on’ position at +$14,202.50.  The average entry price point for the three short sales is +$17,672.50.

This Week’s Price Action

The Dec-Nov soy meal (x2)/soybean spread has exploded higher in the last couple of days.  Intraday, the spread is currently nearing the early September high.

dec-nov-soy-meal-x2-soybean-spread-daily

Dec Nov Soy Meal (x2) Soybean Spread Daily

Furthermore, the spread close back above the 30-day Moving Average yesterday for the first time since July 1st.  It is likely to close above it again today, confirming a bullish trend change signal.

Add this to the seasonal pattern that shows a tendency for meal and beans to both establish major lows in October and you can see that things are now stacking up in favor of the bulls.  To that end, it makes sense to book the profits on this trade.

Trade Strategy:

On the three Dec-Nov soy meal (x2)/soybean spreads entered at +$21,125 (premium meal), +$17,690, and +$14,202.50, exit at +$14,202.50 or better or at the market-on-close, whichever occurs first.

Soybean/Cotton Spread: Let’s Book the Profits

Taking the Money Off the Table

The IMC blog entered a short position in the Nov-Dec bean/cotton spread at +$22,365 (premium beans) on June 23rd.  Based on the way it has behaved in August, we’re inclined to book the profit and wait for a new setup to go back in.

First of all, the spread had price support at a double bottom between the August 21, 2015 low of +$11,382 and the December 28, 2015 low of +$11,430.  This support area was breached on August 1st and the spread stayed below this level for a full week.

Nov-Dec 2016 soybean cotton spread daily (support line)

Nov-Dec 2016 soybean cotton spread daily (support line)

This should have led to an accelerated decline toward the ‘even money’ level.  Instead, the spread reversed and closed back above the double bottom on August 9th.  This failed breakdown is something we call a Wash & Rinse pattern.  It’s a bullish sign.

The second bullish development for the Nov-Dec bean/cotton spread occurred on August 15th when it closed back above the 30-day Moving Average.  The January-June run higher was supported by the 30-day MA and the July meltdown was capped by the 30-day MA.  Now that the spread is back above the 30-day MA it is in a bullish position again.

Nov-Dec 2016 soybean cotton spread daily (3-day MA)

Nov-Dec 2016 soybean cotton spread daily (30-day MA)

The Nov-Dec bean/cotton spread made a sharp pullback last week and it seems to have stabilized above the 30-day MA.  Therefore, we’ll use it as an opportunity to cover the short position.  After that, we’ll monitor the spread for a setup to get back in.

Trade Strategy:

On the short position in the Nov-Dec bean/cotton spread entered at +$22,365 (premium beans), liquidate the position at +$14,865 or better.

Meal/Bean Spread: Pyramid Criteria Was Met

Double Up

The blog entered a short position in the Dec-Nov soy meal (x2)/soybean spread at +$21,125 (premium meal) on June 23rd.

The blog entered a second short position in the Dec-Nov soy meal (x2)/soybean spread at +$17,690 (premium meal) on August 2nd.

December Soy Meal Soybean (x2) spread daily

December Soy Meal Soybean (x2) spread daily

We are now short a pair of spreads from an average price of +$19,407.50.  Both positions will be risked to a two-day close above +$20,690 (premium meal), which is $3k above the ‘add-on’ entry price.

At the very least, we are looking for the December spread to return to the April 4th contract low of +$8,975.  However, historic precedent makes it a reasonable expectation for the spread to ultimately make it to ‘even money’ or lower.  Therefore, we are going to continue adding to the short position in $3k intervals.

‘Add-On’ Trade Strategy:

The blog will sell a third Dec-Nov soy meal (x2)/soybean spread on a close below +$14,690 (premium meal).  If filled, exit all three spreads on a two-day close of $3,000 or more above the entry price of the third spread.

If the third position is entered, sell another Dec-Nov soy meal (x2)/soybean spread on a close $3,000 below the entry price of the third position.  If filled, exit all four spreads on a two-day close of $3,000 or more above the entry price of the fourth spread.

To enter a short position in this spread, sell two 100-ton December soy meal contracts and simultaneously buy one 5,000 bushel November soybean contract.

Meal/Bean Spread: Build the Pyramid

Full Court Press

On June 23rd the IMC blog initiated a short position in the Dec-Nov soy meal (x2)/soybean spread at +$21,125 (premium meal).  The spread touched a two-month low this morning, so the trade is making some headway.

Prior tops at +$20k or higher (premium meal) were followed by drops back under +$9k (premium meal).  Therefore, we fully expect the Dec-Nov soy meal (x2)/soybean spread to return to the April 4th contract low of +$8,975.

December Soy Meal Soybean (x2) spread dailyFurthermore, prior to the 2012 drought, tops established north of +$20k were followed by bear market declines to ‘even money’ or lower.  So a break of the April low could indicate that the Dec-Nov soy meal (x2)/soybean spread has further downside potential of several thousand more dollars.

Given the fact that the spread seems to be in a fast decline and our minimum downside price expectation is several thousands of dollars away, it makes sense to pyramid this position to take full advantage of the decline.

Setting the Intervals

We’re going to add more short positions as the spread declines.  The ‘add-on’ positions will be entered in intervals as the down trend continues.  The trick, of course, is to know where to set those ‘add-on’ intervals.

One method I like to use is to measure the countertrend moves of the prevailing trend to get a sense of how much room we need to give the spread.  Then set the intervals at a size that is wider than the countertrend moves.  That way, we are allowing the market to have the breathing room that it has already demonstrated that it needs.

Since peaking on June 10th, the largest countertrend bounce in the Dec-Nov soy meal (x2)/soybean spread was the $1,970 rally off the June 24th low.  Therefore, the blog will use intervals of $3,000 to add to the position.  This is more than 50% bigger than the largest countertrend bounce to date, so the spread should have plenty of elbow room.

‘Add-On’ Trade Strategy:

The blog will sell another Dec-Nov soy meal (x2)/soybean spread on a close below +$18,125 (premium meal).  If filled, exit on a two-day close of $3,000 or more above the entry price.

If the ‘add-on’ order is filled, sell a third Dec-Nov soy meal (x2)/soybean spread on a close $3,000 below the entry price of the prior ‘add-on’ position.  If filled, exit on a two-day close of $3,000 or more above the entry price.

If the second ‘add-on’ order is filled, sell a fourth Dec-Nov soy meal (x2)/soybean spread on a close $3,000 below the entry price of the most recent ‘add-on’ position.  If filled, exit on a two-day close of $3,000 or more above the entry price.

To enter a short position in this spread, sell two 100-ton December soy meal contracts and simultaneously buy one 5,000 bushel November soybean contract.

 

Meal/Bean Spread: Is the Blast Over? Sure Looks Like It

What Goes Up…

Must come down!  Eventually.  Based on yesterday’s close, now might be the time for the Dec-Nov soy meal (x2)/soybean spread to do so.

This spread closed below the rising 30-day Moving Average yesterday for the first time since early April.  This triggered the blog’s short sale signal.

Dec-Nov Soy Meal Soybean (x2) spread daily

Dec-Nov Soy Meal Soybean (x2) spread daily

The IMC blog entered a hypothetical short position when it sold two 100-ton December soy meal contracts at $381.00 (total value of $76,200) and bought one 5,000 bushel November soybean contract at $11.01 1/2 (contract value of $55,075).  This puts us short at +$21,125 (premium meal).  We will initially risk the trade to a two-consecutive day close above +$24,250 (premium beans).

If/when the spread gives us some setups for pyramiding, we will be sure to address it.  But if you have your own methodologies for doing so, don’t wait around for us!  Take advantage of it.  This could be just the start of a beautiful bear market.

Soybean/Cotton Spread: Bearish Trend Change Triggered!

The Great Unraveling…Hopefully

Yesterday the Nov-Dec bean/cotton spread closed below the rising 30-day Moving Average for the first time since the first week of 2016.  This signaled a bearish trend change and elected the blog’s criteria for a hypothetical short sale.

The November soybean contract was sold short at $11.01 1/4 (contract value of $55,075) and the December cotton contract was purchased at 65.42 (contract value of $32,710).  This puts us in the spread at +$22,365 (premium beans).  Initially, we are risking a two-consecutive day close above +$26,400 (premium beans).

Nov-Dec 2016 soybean cotton spread daily

Nov-Dec 2016 soybean cotton spread daily

Recall from the previous post that prior excursions to +$20,000 (premium beans) or higher have been followed by bear markets that took the spread down to at least even money.  Therefore, we anticipate that we’ll see some pyramiding opportunities to take full advantage of the decline.  Once we have a big enough open profit on this trade we will examine the market volatility and price patterns to determine the best course of action for ‘add-on’ trades.

Meal/Bean Spread: Ripe For a Bear Market

Another Soy Play

Yesterday we posted an article on the spread between soy meal and bean oil.  Today we also want to point out an opportunity in the spread between meal and soybeans.  Remember, meal is a direct derivative of the beans, much like gasoline is a direct derivative of crude oil.  So a strong price correlation between the two should come as no surprise.

Soybeans Soy Meal overlay weekly

Soybeans Soy Meal overlay weekly

Take a glance at the last forty-five years of weekly closing prices of soy meal and soybeans.  The charts show an undeniable link between the price action and trends of these two markets.

The Bean/Meal Ratio

On the weekly nearest-futures chart, the ratio between the value of one 5,000 bushel soybean contract and the value of one 100-ton soy meal futures contract recently sank to a one and a half year low of 1.35:1.  Historically, the ratio has only dropped below 1.4:1 about half a dozen times in the last forty-five years.  Therefore, it’s worth paying attention to.

Soybeans Soy Meal ratio weekly

Soybeans Soy Meal ratio weekly

Prior drops below 1.4:1 have been followed by multi-month and even multi-year rallies.  So the recent drop below 1.4:1 tells us that the stage for a major rally is being set.  Using this precedent, it makes sense to start watching for trend change signals to time the turnaround.

Spread It Out

We’re going to take a look at spread between the value of the sum of two soy meal contracts and one soybean contract.

At the June 10th high, two December soy meal contracts were valued at a premium of +$23,722.50 over the value of one November soybean contract.  Historically, the spread has been a great short sale candidate whenever the meal reached a premium of +$20k or more over the beans.

Soy Meal Soybean (x2) spread weekly

Soy Meal Soybean (x2) spread weekly

Prior tops at +$20k or higher (premium meal) were followed by drops back under +$9k (premium meal).  Tops above +$20k (premium meal) prior to the 2012 drought were even followed by bear markets that took the spread back to ‘even money’ or lower.  In light of this, a spread trader should be watching for a place to short the soy meal (x2)/soybean spread when it rolls over.

Trend Change Signal

After establishing the contract low in early April, the Dec-Nov soy meal (x2)/soybean spread has rocketed higher.  It posted new contract highs just six weeks after the contract low and continued to run several thousand dollars more.

Dec-Nov Soy Meal Soybean (x2) spread daily

Dec-Nov Soy Meal Soybean (x2) spread daily

All good things come to an end.  Since the spread has closed above the rising 30-day Moving Average every single day for more than two months straight, a close back below the 30-day MA could indicate that the end has arrived.  If so, the blog will take a crack at the short side of the soy meal (x2)/soybean spread.

Trade Strategy:

The blog will work a hypothetical order to sell two 100-ton December soy meal contracts and simultaneously buy one 5,000 bushel November soybean contract if the spread closes below the rising 30-day MA (currently around +$21,725).  If filled, exit on a two-day close $500 above the contract high that precedes the entry.

Soybean/Cotton Spread: When Will It Unravel?

Playin’ It Loose

We’re going to take a look at a spread that has a sloppier correlation than most: the soybean/cotton spread.  The reason for the lower price correlation in this spread is obvious since there isn’t exactly a strong bond between the fundamental demand factors.  After all, you can’t exactly substitute soybeans for cotton or vice versa.  When was the last time you went to Gap and bought some jeans and T-shirts made out of soybeans?  Or ordered a cotton milk latte at the local coffee shop?

However, there are some commonalities between these two crops.  The growing season is the first thing that comes to mind.  Both soybeans and cotton crops in the US are planted in late spring/early summer and harvested in the autumn.  The specific dates will differ, depending on the weather conditions and which state the crop is grown in.

Another commonality is where the two crops are grown.  Many of the same states have land that can accommodate both soybean and cotton crops.  Because of this, you can get a lot of crop rotation where farmers will switch from raising one crop to the other.  This usually depends on the price differences between the two crops.

Since the crop years and locations are similar, it also means that the weather patterns can have a similar impact on both crops.  A good planting season that leads into ideal summer growing weather, followed by agreeable harvest conditions can mean bumper crops in both beans and cotton.  Conversely, a US drought in June or July can simultaneously wipe out both crops.

Soybeans & Cotton = A Volatile Relationship

When you compare the price charts of how these two markets have interacted over the last four decades, it appears that the relationship between the two has been as tumultuous as Rihanna & Chris Brown; sometimes the two run together, sometimes they seem to repel each other.  At the end of the day, though, they always seem to get synced back up.

Soybean Cotton overlay weekly

Soybean Cotton overlay weekly

This lower correlation means that the spread between the soybeans and cotton is more likely to experience outliers than something with a stronger correlation like crude and gasoline, gold and silver, feeders and live cattle, etc.  However, we still like to play it the same way.  First, we look for the soybean/cotton spread to reach levels that it rarely gets to.  Then we look for a change in the price action to tell us when to get involved and enter a position.

Historic Spread Levels

To examine the spread relationship between soybeans and cotton in the futures markets, we don’t just compare the prices of the two markets.  Instead, we look at the difference between the values of the 5,000 bushel soybean contract and the 50,000 lbs. cotton contract.

soybean cotton spread weekly

soybean cotton spread weekly

Looking at 45 years of price history (basis the nearest-futures weekly closing prices), it appears that the spread is expensive whenever a soybean contract is worth $20,000 or more than a cotton contract.  Conversely, the spread is historically cheap whenever a cotton contract is worth $10,000 or more than a soybean contract.  It may take months or it may take years, but whenever the soybean/cotton spread hits or surpasses either one of these levels it has ultimately reversed and gone back to even money where the two contracts have the same value.

Normalize It

Given the fact that the ag and grain markets have had some huge moves in the past and the fact that soybeans are priced at levels that were unheard of until less than a decade ago, it is possible that the spread relationship between beans and cotton can be unrealistically skewed.  The ratio can help us determine if this is the case or not.

soybean cotton ratio weekly

soybean cotton ratio weekly

Using the same 45 years of price history, we can get the bird’s eye view of the soybean/cotton ratio.  By our account, the ratio is expensive whenever it reaches 1.8:1 or higher (where a soybean contract is worth at least 80% more than a cotton contract) and it is cheap whenever it sinks to 0.66:1 or lower (where a cotton contract is worth at least 50% more than a soybean contract).

Armed with both the spread and ratio parameters, we can now look at the current situation to see if a trading opportunity is materializing.

Where It Stands

This year started out with the new crop spread between November soybeans and December cotton priced either side of +$12k (premium beans).  This was certainly nothing to raise eyebrows.  However, the spread started trending higher from the early January lows and hit the +$20k threshold in early May.

Here we are a month later and the spread is accelerating.  Today it closed at a new contract high of +$24,532.  This is a strong bull run.

Nov-Dec 2016 soybean cotton spread daily

Nov-Dec 2016 soybean cotton spread daily

The Nov-Dec bean/cotton ratio hasn’t quite reached the historical expensive marker of 1.8:1 yet, but it’s getting close.  So far, the ratio has reached 1.76:1.  It wouldn’t take much to ring the bell at 1.8:1 sometime soon.

The bull run in this spread has been supported by the rising 30-day Moving Average.  The Nov-Dec bean/cotton spread has closed above the 30-day MA every single day for five consecutive months.  In addition, the pullback in early April and the correction into late May both stopped near the 30-day MA.  Therefore, the IMC blog will use a two-day close below the 30-day MA for the first time since the first week of 2016 as a green light to take a shot at the short side of the spread.

Trade Strategy:

For tracking purposes, the blog will make a hypothetical trade by selling one 5,000 bushel November soybean contract and simultaneously buying one 50,000 lbs. December cotton contract on a close below the rising 30-day Moving Average (currently around +$21,332).  Initially, the spread will be liquidated on a two-consecutive day close $500 above the contract high that precedes the entry (currently +$24,532).