There are credible fundamental reasons why wheat rallied in early October: tight supplies and an Australian drought wiping out 50% of its estimated crop. And given the rally and tight supplies in the old crop, you could see how a bull spread position would be profitable.
This raises the question: why were so many locals hurt in what one market observer called a “blood bath?” One source estimates the loss by wheat locals in the pit to be between $80 to $100 million.
The reason is explained in detail in “Long opportunities?” (see below) where veteran trader Tom Willis describes a nightmare scenario. That nightmare occurred for floor traders and other bear-spreading wheat traders hoping to take advantage of the upcoming index fund rolls. They have consistently been able to profit from the funds largesse with bear spreads — often despite bull markets — but fundamentals and a 12-year high in wheat won out.
Wheat spreads have moved more than $1 in a matter of days and most locals were on the wrong end of that move. Veteran trader Bob Wiedeman describes what happened as the perfect storm. “The world changed on them really quick, it is a bear spreader’s nightmare.”
The Chicago Board of Trade (CBOT) on Nov. 9 had to enforce a rarely used regulation forcing traders to reprice December 06/July 07 spreads to 55.5¢ because trades executed above that price fell outside of the daily limits. Mark Nagle, VP of Dorman Trading, says locals were executing that trade up to 70¢. According to the CBOT, all trades above 55.5¢ will be repriced and executing parties will make the appropriate cash adjustments.
Many locals had attempted to get a jump on the March roll and were short March ’07 wheat and long July ’07. That spread went against them by more than $1 in the week of Oct. 9.
Justin Kelly, research analyst for Iowa Grain, blamed it on a combination of supply shortages in the old crop, higher planting intentions in the new crop and the market taking advantage of out-of-positions hedges. “If you are in a bear spread, nobody is going to sell you the December.”
And the nightmare may not be through. The bulk of the long-only funds are long front-month wheat and won’t be getting out until November. “It is going to be a very difficult roll” says one insider, “It is not going to be a half-cent spread; it is probably going to be much wider.”
