Commodity trading strategies. Part 4:
https://www.publish0x.com/real-world-assets/commodity-trading-strategies-part-4-xvmgdje
Crush spread
Crush spread is a trading strategy used by soybean traders to manage risk. The strategy involves soybean, soybean oil and soybean meal. Soybean oil and soybean meal are produced by crushing of the beans which gave the strategy its name. Crush spread is simultaneously entering three futures contracts (or options), usually by going one leg and shorting two legs or going long two legs and shorting one leg. In particular, in the soybean market a long crush spread refers to buying soybean oil and soybean meal futures contracts and selling soybean contracts.
Crush spread can be employed by hedgers to secure their profit margins. For example, operators of crush mills use the strategy to guarantee the value of their final products relative to the price of their input, soy beans. In this sense, crush spread is not different from crack spread employed by oil refineries. A crack spread is the difference between the price of a barrel of crude oil and petroleum products refined from it. Since at times the pricing difference may be too volatile, refiners trade futures contracts to lock in their profit margins.
To benefit from crush spread you don’t have to operate in the soybean industry. Speculators also can employ the strategy if they believe the spread is too narrow which means soybean oil and meal prices are low relative to soybean prices. If they expect that the final products (oil and meal) will appreciate in value, they can buy the spread. To enter a crush spread trade is preferable than just buying soybean oil or meal because by shorting soybean futures you minimize price risk. The spread can be sold short too, if the spread is too high, and a trader believes that it will go down.
Old crop vs new crop
Yet another trading idea that can be employed with soybeans is old crop versus new crop. When grain is harvested, only the grain stock that was harvested from the previous season is available for purchase or sale; hence the name old crop. After several months the harvest season comes in and the newly harvested crop is available to the market; hence the name new crop. In soybean trading, July and November futures contracts are old crop and new crop futures respectively.
To understand how we can trade July - November soybean spread, we should look at the supply-demand dynamics during these periods. As mentioned above, during the old crop period, soybean prices tend to be high due to the low supply. On the other hand, new crop bring more grain to the market which depresses the prices. That is why the annual lows of many grain markets are experienced in new crop months.
Historically, this spread has been too volatile because it depends on too many factors, such as weather, acreage, yields, soybean demand etc, and also because we are dealing with two different crop years. Even if the overall direction of the soybean market is bullish or bearish, the July and November futures can move in different directions. The July contract tends to trade at a premium to the November contract. The spread tends to go down (i.e, July contract price decreases vs November) when grain stocks are adequate. Conversely, the low level of stocks causes the spread to strengthen which means July premium over November increases.
At this point you may ask how we know that stocks are ample or not; which benchmark do we compare stocks to? If we know that ending stocks of soybeans in the US is 1 million bushel, we are not sure if this number is high or low so this doesn’t tell us anything. It turns out that there is a measure of supply and demand relationships of a particular commodity. This measure is the stocks-to-use ratio.
How can we get or calculate ourselves the ratio for soybeans? United States Department of Agriculture’s monthly World Agricultural Supply and Demand Estimates (WASDE) report provides a detailed forecast of supply and demand for many agricultural commodities. The stocks to use ratio indicates the level of stocks as a percentage of the total demand. The ratio is a good, convenient measure of whether stocks are adequate. If the ratio is low, especially compared to previous years’ figures, it may predict high prices. Conversely, stock to use ratio being higher tends to be followed by lower prices.
The author of an interesting article on dtnpf.com points out a historical pattern based on 1990-2017 data. When supplies were low and the stocks to use ratio was less than 5%, the July-November spread tended to increase. On the other hand, when the stocks to use ratio is higher than 10 percent, the spread has historically decreased; the weakening of the spread continued until June. How can we execute this idea? Look at the last WASDE report and find soybean ending stocks and usage numbers. If the stocks to use ratio is below 5 percent, buy July soybean contract and sell November contract; conversely, if the ratio is higher than 10 percent, do the opposite - sell July and buy November betting on the falling of the spread.
