A dramatic weather event last week in the Southern Plains could significantly influence future wheat prices. An untimely hard freeze no doubt caused crop damage and killed a portion of the immature wheat crop.
The exact loss can’t be definitely known until harvest time, but estimates range from 20 million bushels lost all the way up to 100 million.
In this week’s article, I’ll present a way to capitalize on this development–and it’s not by buying wheat futures. Rather, it involves a “spread” in the wheat market.
Spreads are a more sophisticated way of trading that fits well into the game plan of many traders. I know some traders who only trade spreads because they feel this is the best way to limit some of the risk inherent in futures and options. Actually, this is the main purpose of spreading: to reduce risk.
When you enter a spread, the objective isn’t necessarily to make money on a rise or fall in the market in question; rather, the emphasis is on a change in the relationship between different prices.
When you put on a spread, you buy one contract while simultaneously selling another. You’re long and short in either two related commodities or two different months of the same commodity at the same time. The relative change between the two determines your profit or loss.
There are two major categories of spreads, “intramarket” and “intermarket.”
An intramarket spread consists of buying one month in a particular commodity and simultaneously selling a different month in the same commodity. Examples include buying July corn and selling December corn, buying March crude oil and selling April crude oil, buying May cotton and selling December cotton.
Because you’re trading two different months in the same commodity, one long and the other short, their prices will tend move in the same direction. How can you possibly make money in a spread? Although they may tend to move in the same direction, they don’t have to, and even when the two months move in the same direction they tend to move at different speeds. Although many times when you gain on one side of a spread you lose on the other, what you’re looking for is a bigger gain on the winning side than your loss on the losing side.
An intermarket spread consists of buying one commodity and simultaneously selling a related commodity. Examples include buying silver and selling gold, buying hogs and selling cattle, and our trade of the month, which involves buying one wheat variety and selling a different variety.
In these examples the two markets are related, and they generally move in the same direction because the same market forces affect both. However, they’ll move at different speeds.
You may decide to buy July corn and sell July wheat. Both are grains, they can both be used for animal feed, and both are export commodities. They’ll tend to move in the same direction. However, if the fundamentals are strongly opposed they could move in opposite directions.
Let’s take up a hypothetical. It’s March, and you believe corn supplies are tight, but wheat supplies will grow as the market moves closer to the harvest in the early summer. July corn is at $3.10 and July wheat is at $4.50, so you buy the corn and sell the wheat with corn at a 140 discount to the wheat. (You should read the order with the long, or the buy side, first.)
Intermarket spreads can’t be classified as “bull” or “bear,” as can intramarket spreads. Suppose a few months go by and both corn and wheat fall in price, corn to $2.80, wheat, due to harvest selling pressure, to $3.60. You decide it’s time to unwind the spread. You buy the July wheat, sell the July corn, offsetting both sides of the spread and wiping your slate clean.
The long side–the corn side–shows a loss of 30 cents, the short side a profit of 90 cents. Your gross profit is the difference of 60 cents. Because in grains a penny move is worth $50 per contract traded, this is a profit of $3,000 per spread.
Note that you put the spread on at a 140 discount and took it off at an 80 discount; the difference between 140 and 80 is 60. In this case you wanted the spread to narrow; you wanted the lower-priced corn to gain on the higher-priced wheat, and it did. If the corn fell by 40 cents and the wheat by 20 cents, you would have lost 20 cents on the spread. If there were weather problems with the new-crop wheat, and the spread widened to 190, (wheat went up 40 cents and corn fell 10), you would have lost 50 cents, or $2,500 per spread.
Trade of the Month: An Intermarket Wheat Spread
I’ve already recommended this trade to Futures Market Forecaster subscribers, and I currently have it open in my own an account.
Long July Kansas City Wheat vs Short July Chicago Wheat
Source: Commodity.com
The above chart shows the spread is trending higher.
Kansas City Wheat represents the HRW (hard red winter) variety used for bread baking. Chicago Wheat represents the SRW (soft red winter) variety used in cakes and pastries. These two varieties are, for the most part, grown in different areas, with more SRW grown in Illinois, Ohio and Missouri. The primary variety grown in the Southern Plains is–you guessed it–HRW.
The July contract for both represents the new crop–the wheat that was planted last fall, is in the ground now, and will be harvested early summer.
The expectation for entering this spread with Kansas City as the long side is that the HRW will either rise faster or fall slower than the Chicago/SRW variety. I liked this spread before last week’s freeze hit the Southern Plains because this area has been experiencing drought conditions this year. This recent weather event should tighten the HRW supply situation even further in relation to the SRW and only strengthens the case for the spread in my mind.
Specifically, I believe the spread is a buy as long as the Kansas City wheat is at or less than a 50-cent premium above the Chicago. I’d risk to a close below a 40 premium over the Kansas City and expect the spread to reach, at minimum, an 80-cent premium to the Kansas City. Every penny per bushel the spread changes results in a profit or loss of $50 per spread. Based on my parameters the risk is in the neighborhood of $500 per spread traded with a profit potential three times the risk.
Most brokers will provide a margin break for an intermarket spread, only requiring only one wheat margin be posted rather than two.
Although perhaps slower moving than an outright position in the wheat market, in my mind this year the direction of the spread, while still involving some risk, is more predictable.
For additional trade recommendations, consider George Kleinman’s subscription-based service, Futures Market Forecaster. And be sure to check out George’s new book, The New Commodity Trading Guide, available now at Amazon.com.
Risk Disclaimer
Futures and futures options can entail a high degree of risk and are not appropriate for all investors. Commodities Trends is strictly the opinion of its writer. Use it as a valuable tool, not the “Holy Grail.” Any actions taken by readers are for their own account and risk. Information is obtained from sources believed reliable, but is in no way guaranteed. The author may have positions in the markets mentioned including at times positions contrary to the advice quoted herein. Opinions, market data and recommendations are subject to change at any time. Past Results Are Not Necessarily Indicative of Future Results.
Hypothetical Performance
Hypothetical performance results have many inherent limitations, some of which are described below. No representation is being made that any account will or is likely to achieve profits or losses similar to those shown. In fact, there are frequently sharp differences between hypothetical performance results and the actual results subsequently achieved by any particular trading program. One of the limitations of hypothetical performance results is that they are generally prepared with the benefit of hindsight. In addition, hypothetical trading does not involve financial risk, and no hypothetical trading record can completely account for the impact of financial risk in actual trading. For example, the ability to withstand losses or to adhere to a particular trading program in spite of trading losses are material points which can also adversely affect actual trading results. There are numerous other factors related to the markets in general or to the implementation of any specific trading program which cannot be fully accounted for in the preparation of hypothetical performance results and all of which can adversely affect actual trading results.
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