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

Grain & cattle spreads: Finding an edge

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.

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