In today's post I'll share a commodity trading strategy.
Similar commodities tend to be highly correlated which can be exploited profitably. For example, historically soybean traded at premium to corn with the ratio of 2.5.
Farmers who are, like most of us, profit-maximizing economic agents will choose which crop to grow on their acreage. When the soybean to corn ratio is near or at 2, it then reverses to its historical average which means soybean appreciates more in value than corn. The pattern is not just a statistical one but follows supply-demand laws. When the ratio is high (at or near 3), it implies that soybean is more profitable than corn. That’s why farmers will plant more soybeans which will depress soybean prices. The opposite is true when the ratio is at or near 2; corn being more profitable for farmers will be followed by taking more corn than soybean to the markets which in turn will decrease corn prices.
I looked at data going back to 2014; there's a pattern that when the soybean/corn ratio is near 2, buying soybean and selling corn was profitable. Conversely, when soybean price was three times higher than that of corn, selling soybean and buying corn offered a more attractive return. Historical average profit was $2,500-$3,000 per lot. Max profit was $7,460, max loss was $-600 per lot.
From the chart we can observe that in 2019 summer and 2021 summer, the ratio fell to 2 which then in both cases was followed by its reaching to historical mean of 2.5 after approximately two months.
Now the ratio is 2.82, i.e., soybean is trading near the historical highs relative to corn. So, one can sell soybean and buy corn. To remain dollar-neutral, the better idea is to short 1 soybean lot and buy 3 corn lots.