From the November 01, 2011 issue of Futures Magazine • Subscribe!

Grain & cattle spreads: Finding an edge

Spreads between pairs of futures are possible when the two underlying assets have price movements that are linked in a measurable and predictable way. This was shown to be the case between gold and silver ("Gold & silver: Always good options," May 2011) and also is true with futures and options on agriculture-based assets such as grains and livestock. Pairs trading in the ag market are formally recognized by the CME Group with products that include wheat-corn intercommodity spreads and synthetic soybean-corn price ratio futures.

One way to measure relative price movements between two related futures contracts is by observing the differences in daily percentage price changes. Corn futures are used as the benchmark price change related to four other futures on the following charts: "Live cattle minus corn," "Lean hogs minus corn," "Soybeans minus corn" and "Wheat minus corn" (see "Influential corn," below). December 2011 futures are used for live cattle, lean hogs and wheat, while corn and soybeans are compared using March 2012 futures.

The effects of corn price changes are apparent in all four charts, most notably the plunge in December corn on June 30 and July 1 — a loss of 8.29% in two days. The large positive percentage difference for the other four futures would have indicated a good time to sell wheat, soybeans, live cattle or lean hog futures and buy corn futures.

On the four charts, there are opportunities for pair spreads at the plus and minus 2% level, as well as a number of stronger 4% differences. Experience over time should indicate the difference required to make a successful pairs spread trade.

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