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.
In addition to futures price changes, put and call options may be used in pair spreads. "December calls" (below) shows corn, wheat, live cattle and lean hog calls on Aug. 23, 2011.
Wheat and corn option price curves are related closely, while live cattle and lean hog curves are lower. Options for the two meat futures are priced lower because of the market’s forecast of smaller price spreads before expiration day – in other words, lower volatility. As shown by the chart, the option premiums as a percent of strike price range from more than 7.5% for corn and wheat, to 6% for lean hogs and 4% for live cattle.
Two of the forces at work on the call price curves are:
- The daily erosion of time to expiration continues to reduce the premiums of puts and calls until eventually the premium will disappear and the option will be priced at either zero for out-of-the-money options, or intrinsic value (the underlying futures price less the strike price) for in-the-money options, and
- Volatility differences perceived by the market, causing low-volatility options to fall more rapidly as time passes — an advantage held by options having larger estimated price spreads at expiration.
"Soybeans and corn" (below) illustrates the edge provided by higher volatility, with the March corn option curve at a height of over 8% compared to the height of March soybean calls at approximately 6%. Unless the market changes its opinion of comparative price volatilities, this means that over time soybean calls will lose value faster than corn calls. As the pair moves closer to expiration, this valuation difference should be taken into account in trading soybean-corn option pairs. Because the volatility advantage is option-centered, its effect on the CME Group’s synthetic soybean-corn price ratio futures is indirect — indicating the options market’s forecast of price changes in the futures contracts.
On "December calls" (above) wheat and corn option price curves are approximately the same height where the underlying equals the strike price. In fact, "December calls" shows that wheat and corn curves are almost identical. Thus, there is no volatility advantage to either of the futures, and decisions on trading spreads for this pair depend on variations in percent changes of price or price ratios.
The option price curve showing the least expected volatility and, thus, the most vulnerable to the loss of premium because of time erosion is that for December live cattle. With approximately 90 days to expiration, the calls are subject to the effect of time — a small amount of time premium is expected to be lost each day. According to their relative positions on the price curve chart, corn calls should have an advantage over live cattle in terms of time decay.
A profitable spread trade
An example of a paired trade between corn and live cattle is originated on July 29, when the spread indicator based on percent price change is plus 3.117 % — a direction that would tend to favor selling December live cattle futures and buying corn futures. On July 29, cattle futures are sold at 119.825 while December corn is bought at 668.75. The following trading day, Aug. 1, December cattle futures are bought at 120.775 and corn is sold at 685.75. Each point of live cattle futures is $400 and the corn futures point value is $50. Thus, the trade loses $380 on cattle futures and gains $850 on corn, resulting in an overall profit of $470.
The close relationship between corn and wheat futures could be a disadvantage in spreads involving these commodities. Over the period May 2 through Sept. 27, 2011, the number of days on which wheat, cattle, hogs and soybean futures changed more than 2% in price compared to the price change for corn futures were counted – positive spreads when the following day’s price change reversed and negative results when the two days were both either positive or negative. Cattle and soybeans produced the best results, 15 to 10 (positive to negative) for cattle and 12 to seven for soybeans. Only moderate results were counted for wheat and hogs, nine to eight for wheat and 17 to 16 for hogs.
Volatility difference assisted spread
A spread between December corn and lean hogs on Aug. 23, 2011 buys one 760 strike corn call priced at $2,143.75 with futures at 743.5, and sells two of the 90 strike price for lean hogs at $930 each when futures equal 84.325. When the spread is closed out on Sept. 2, corn futures have increased to 760 and the 760 calls are $2,400. Lean hogs 90 strike calls are $610 each with futures having decreased to 83.100. Aside from costs the spread profit is $896.25.
These spread examples illustrate that a number of variables combine for the results — changes in the prices of the underlying futures, pricing of options by the market, the number of options used to offset buy and sell orders and the decision as to when to close out the trade.
Knowledge of comparative volatilities gives the spread trader another piece of information pertaining to puts or calls whose price curves appear to be relatively more sensitive to the declining of time to expiration.
Over time, as spread trading increases based on related pairs of futures and options, it is possible that the profit potential will decline when many traders act on the same ratios or percent differences. Even without this effect there will be periods in which the ratios and percent differences will decline. Traditional fundamental factors and trend differences also will be important in spread trade decisions. Ultimately, charting price changes and price ratios provide just a marginal edge, but one that can make the difference between profitable and unprofitable trades.
Paul Cretien is an investment analyst and financial case writer. His e-mail is PaulDCretien@aol.com.