Trading Grain Spreads Using a Fundamental Approach

The objective of this thread is to initiate and encourage an ongoing discussion regarding the use of fundamentals for trading grain spreads. I am willing to share some of my strategies/experiences and encourage others to do the same. Questions are welcomed and will be answered whenever possible.


I use a fundamentals to trade commodity spreads because that is the approach that I was taught. I started with a grain company in 1983 as a junior trader, trading both cash and futures. Commercial traders (in my case an elevator company) are responsible for managing futures positions that are perpetual, perpetual in the sense that they are almost always short futures in the case of suppliers and long futures in the case of end users. The perpetual futures positions of commercials are, in theory, offset by an equivalent cash (or physical) position. Commercials are, therefore, required to "roll over" their futures position from one month to another based on their cash positions. Hence my fundamental approach to trading spreads.

I can understand how the spread between consecutive months may appear arbitrary to new traders. Nothing could be further from the truth. When a spread is at a carry, the market is satisfied that there is sufficient deliverable stocks to offset the open interest fo the nearby contract. When a spread is at inverse, the market is concerned that there is insufficient stocks to satisfy nearby demand and is willing to pay a premium in order to secure those stocks. I will cite an example to stress my point.

Around 1990, a contract that I traded entered into a delivery period. As the delivery period progressed, there were two participants remaining, Cargill (the long) and a smaller grain company (the short). It appeared that the short didn't have stocks in a deliverable position to satisfy the remaining open interest and would have to offset their futures poition by going into the pit and buying the futures back. Consequently, the spread went to a large inverse. I remember leaving the floor one afternoon when the spread closed at a huge inverse (Cargill would "enhance" the spread whenever possible) and thinking the squeeze would only accelerate. The next morning the market opens and the spread collapses to full carry. The short had "borrowed" stocks from another commercial and delivered against their short futures position prior to teh market opening. There was no longer a need for the market to pay a premium for the nearby since the deliverable stocks were sufficient to offset the open interest and the squeeze was over.

A number of conclusions may be drawn from the above example. First, the movement in the spread was directly related to the fundamentals and in particular the deliverable stocks.
Secondly, while in the delivery month, only the stocks that are in a position to be deliverable are relevant to the spread. This is not a garme of horseshoes or hand grenades where "close counts". If it is not in a deliverable position, it does not threaten delivery and does not come into play.
Thirdly, the spread stopped at full carry once the short made delivery. I will venture to say that carrying charges is a crutial component to trade in any cash commodity, whether it is grain, crude, coffee, sugar, cattle, hogs, rice, orange juice, I think you get my point. Likewise, carrying charges define parameters for futures and should not be dismissed.

Regards, local

 

So the short had to pay a premium to cover a portion of their position, do you know how big of a hit they took on those contracts?

 

Local, this will be a very interesting year. The cotton is fighting over beans and corn acres.

 

Interesting stuff, Local. Thanks for sharing. I'm looking forward to your future posts.

 

Me too.

Perhaps it is too early in the thread, but I would like to know what local thinks about the growing influence of hedge funds/speculative money in agricultural markets.

Did it change the way you trade?

It has a really tangible influence on outrights, but do they influence spreads as much?

How do you factor it in your fundamental matrix? How important is the COT?

Are they more predictable than other participants, especially in rollover period ?

Is traditional seasonality affected?


Thanks a lot.

 

I don't think is really possible to sa what the losses were. What is important is that the short was able to offset the futures position by delivering rather than buying back the futures. If the short was to buy back the futures, it would have been a case where losses were, in theory, unlimited (within reason).

Another point to be taken from this example is that this was a classic squeeze ( gone wrong). I knew the Cargill trader and it was clear that his long position was not a hedge, purely a speculative position. I have often read posts that describe trading as a "game". This example, although it evolved through the delivery period which few of us will ever be involved in, supports that analogy.

 

At these prices corn is favored over beans. Heard one estimate today that has next year's corn carryout at 1.8 bil, partly due to increased acres, also less demand from ethanol.z11/Z12 would go to even money or worse should that ever happen.

Regards, local

 

Sharp thread!