Trading grain futures can be a trying experience for both new and experienced traders. There are many factors that can affect price action that are unpredictable and have little to due with fundamental or technical market factors. Volatility in the markets due to the activity of hedge funds and index funds as well as daily fluctuations in world currencies can have a major impact on price action. (For background information on trading grain futures, read Grow Your Finances In The Grain Markets.)
Spread markets, on the other hand, are seldom affected by action in world currency markets and are generally more true to fundamental market factors. A huge move, up or down, due to outside market factors will likely affect the action of a spread very little relative to the outright futures price. This is why many grain traders prefer to trade spreads rather than trading outright futures contracts. Let's take a look at the calendar spread in particular to show you why investors flock to these fields. (To really understand options and futures, check out our Option Basics and Futures Fundamentals tutorials.)
A calendar spread in the grain markets, or any futures market, involves buying a futures contract in one month and selling one in a different month for the same commodity. For example, a popular spread in the soybean market is the July/November spread. Traders will buy July futures while simultaneously selling November futures (or vice versa) in order to take advantage of changes in the relationship between the two contract months.
Traders participating in this spread trade care very little about the price of the outright futures market and only care about the spread relationship. In most cases, money will be lost in one leg of the spread but made in another leg of the spread. In a successful spread, the gains in one leg will obviously outweigh the losses sustained in the losing leg. This is sometimes a very difficult concept for new traders to grasp.
There are two basic types of spreads that are relevant here:
|Buy the Nearby / Sell the Deferred = Bull Spread
Sell the Nearby / Buy the Deferred = Bear Spread
The type you choose to initiate will depend on various factors - which are outlined below. (For more information on this type of investment strategy, read Pencil In Profits In Any Market With A Calendar Spread.)
Supply And Demand
Calendar spreads are generally affected by supply and demand factors rather than money flow or outside influences. When there is a rather loose supply/demand scenario in grains (times when supplies are sufficient relative to demand), it is not uncommon to find deferred contracts trading well above nearby months. The difference in prices is known as the "cost of carry". This amount includes the costs of insurance, interest and storage of physical grain, or the dollar amount required to "carry" grain from one month to another.
Spreads will not trade past the cost of full carry, generally. For example, the cost to store, insure and pay interest on a bushel of corn for one month is about 6.5 cents. Since this is the entire cost required, the spread between July and December corn should not move past -39 cents (6.5 cents x 6 months = 39 cents). If a July/December corn spread is at -39, it would be quoted as being "39 under," meaning July is 39-under December.
In most cases, spreads will only trade at full carry if there is ample physical supply of the given commodity. In contrast, spreads will often trade at an inverse if there are low supplies of a commodity. This would mean that nearby contract months would be trading above deferred months in order to ration demand and maintain acceptable supplies. This scenario has taken place many times over the years in the corn, soybean and wheat markets. (Learn how to interpret supply and demand from USDA reports in Harvesting Crop Production Reports.)
Once the basic concept of the spread is known, traders can begin to perform their own analysis of certain spread markets and identify opportunities. When looking at a given spread, traders should gather certain information before taking action.
What has the relationship been historically? Look at the past 15 years and see where the spread has gone seasonally and in situations with similar fundamentals. Most knowledgeable brokers will be able to you provide you with historical spread charts.
Use this information to determine which type of spread to initiate. If a spread generally moves higher through a particular seasonal time frame, traders should be more willing to initiate a bull spread. If a spread tends to move lower seasonally, traders should be more willing to initiate a bear spread. (Learn about gauging market changes in Digging Deeper Into Bull And Bear Markets.)
Examine the supply situation for the given commodity and determine if any demand rationing will need to take place. A commodity that has low supplies relative to past years and a wide spread would be a good target for bull spreaders, especially if the spread tends to work seasonally. The opposite could be said for commodities with historically high supply levels. More detailed analysis will then take place.
All factors involving supply and demand will affect spread markets. A good spread trader will constantly monitor everything from production potential to exports or even trendlines. This combination of fundamental and technical analysis helps spread traders to grasp what is driving the given spread relationship, and decide which spread to trade and how to trade it.