From the November 01, 2008 issue of Futures Magazine • Subscribe!

Spreading the wealth

In the last five years in the world of commodity resources, few sectors have moved as quickly into the mainstream consciousness as the agricultural and soft commodity markets. This is for good reason. Grains in particular have experienced one of the most significant rallies in the sector’s history.

What all traders want to know is whether the ag boom and volatility is here to stay or if it is about to fizzle. Indeed, corn ultimately may prove a victim of its own success. The sudden rush into corn-based ethanol, and the flood of hot investment money that went with it is showing signs of fading. Corn seemed destined to reach $10 – a price that many in the industry agree is not sustainable for the long term, at least not yet (see “Off the highs”).

The driving force behind such high prices has been demand, mostly from traditional feed processors but also ethanol. Corn-based ethanol created a fundamental shift in the demand landscape, and farmers have been planting corn post to post the last several years to take advantage of it.

Even though there has been a good deal of money to be made, the flip side is that the input costs have soared for farmers; everything from fuel and fertilizer to lease rates and seed is more expensive. These days, everywhere farmers turn, it seems as if it costs more money just to keep a farm afloat.

The demand for corn-based ethanol is perhaps showing signs of waning, or at least topping, even amidst the most expensive crude oil prices in history. If ethanol plants old and new start shuttering their doors, the gold rush for corn may come to a swift end, or at least seriously slow down, but that doesn’t mean the other grains won’t pick up speed.

WORLD DEMAND

There is no doubt that we live in a global economy and that worldwide demand for grains and other commodities remains stronger then ever. The new economic world order makes it unfair, at least from a fundamental perspective, to compare the run-up in prices to past commodity bubbles.

Many commodities markets now are traded 24 hours a day, six days per week, and have participants who could never participate before, simply because they had no access. This is unlike any previous era and the factors behind price dynamics, likewise, are like none other.

Now that many of the commodities have pulled back from their highs, we are seeing grain markets return to levels that are much more attractive. Corn and soybeans had shed a good percentage of their gains prior to harvest (see “Poised to bounce?”).

Soybeans have pulled back quite sharply relative to the rest of the complex, which makes them especially attractive. This market is potentially the most susceptible to damage and, therefore, is set up for the biggest windfall in the wake of a return of the bulls.

For most commodity markets, though, the elephant in the room is the potential for a global economic slowdown. If the economy dries up, so does the need for natural resources. However, while the demand for some commodities may wane, others are likely to hold up fairly well. Grains are one of the more resilient markets. The reason is simple. Even if the equity markets tumble and growth slows, people still need to eat. Agricultural commodities tend to hold up pretty well in a contracting global economy.

As the world population surges and markets such as China and India continue to grow at an exponential pace, prices will remain strong for basic commodities such as wheat, corn and soybeans, as well as more “luxury” foodstuffs such as cocoa and sugar.

There certainly is still money to be made in the agricultural sector in both futures and options. However, the volatility comes at the price of exclusion of many traders who don’t have the bankroll to weather the ups and downs. Margins on futures and premiums for options have climbed to levels never seen before and put these markets out of reach for many traders, but there is an answer.

SPREADS WORK

One of the most affordable ways a trader can participate in the grain markets is with spreads. Spreads are simultaneous positions in two or more commodities or commodity months. Because the losses in one position are typically offset by gains in the other, spreads are considered less risky than outright positions. As less risky vehicles, they have much smaller margin requirements than outright positions.

In the current bull market, volatility and, consequently, margin requirements of the grain markets have risen significantly; many traders have been shut out of these markets. Simply put, spread trading can be an excellent alternative for participating in the commodity boom for investors who find other options cost prohibitive. However, despite their value and usefulness, spreading is one of the most confusing areas for both new and even experienced traders.

In spread trading, regardless of whether you’re trading futures or options, what you’re doing is taking a simultaneous long and short position in an attempt to profit. The profit comes from the differential, or spread, between two prices. In terms of options, you are using one option’s sale to underwrite the purchase of the other.

SPREAD TECHNIQUES

There are several specific ways to trade spreads, each good for capturing a potential opportunity in the markets.

A spread can be established between different months of the same commodity (called an inter-delivery spread); between the same or related commodities, usually for the same month (inter-commodity spread); or between the same or related commodities traded on two different exchanges (intermarket spread). In terms of mechanics, you can enter a spread order at the market or you can designate that you want to be filled when the price difference between the commodities reaches a certain point (or premium). Spreads can be as simple or as complex as you may need.

In terms of grains, inter-delivery spreads are popular. A common technique is to trade an old-crop contract against a new-crop contract, such as buying July soybeans and selling November soybeans. The soybeans represented by the July contract are from the previous season, while the soybeans represented by the November contract are from the next, or yet-to-be-harvested, season. If current demand rises, particularly as the result of a short-term demand shock, the July contract will increase in value relative to the November contract. This is an example of a bull spread — that is, when the trader is long the old-crop contract and short the new-crop contract within the same commodity.

A bear inter-delivery spread is short the old-crop contract and long the new-crop contract in the same commodity. This trade might be employed if the trader’s analysis indicates the upcoming harvest may be less than the current market assumptions. This trade has become popular as a way to play the large money flows from funds benchmarked to commodity indexes.

Two specialized spread techniques involve a main commodity that has products created or derived from it. A crush spread, for example, is simply a spread between soybeans and soybean meal and/or soybean oil, sometimes called “putting on the crush.” A crack spread is another example; it involves crude oil and unleaded gasoline and/or heating oil.

There are many pros and cons to spreads, and whether they are appropriate for you depends on your risk tolerance, account size and trading goals (see “Spread pros & cons”). The bottom line, however, is spreads allow a trader to participate in markets that he may otherwise be excluded from. In addition, while the lower margin requirements represent less risk, and therefore less reward, they also allow you to trade more net spread positions as your account and understanding of spread markets grow. The additional cost of this flexibility is the extra transaction charges you incur for the additional spreads.

The grain markets and all the commodities will continue to attract investors, having a significant impact on price dynamics going forward. In today’s rapidly changing commodity markets, more traders are likely to find spreads invaluable for participating in the subsequent price moves.

A WORD OF CAUTION

The dynamics of certain spreads have changed due to the large money flows coming from funds benchmarked to commodity indexes. Certain old assumptions regarding bull and bear spreads may no longer be viable, so you must take into consideration these new fundamentals in the market.

Kevin Kerr is a commodities trader and former member of the New York Cotton Exchange and FINEX. He is also editor of Global Commodities Alert. Reach him via www.kerralert.com.

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