Spreading sugar for profits

August 31, 2014 07:00 PM

Sugarcane is highly versatile—and resilient. Break it, crush it, beat it or grind it, sugarcane always produces sweet syrup. It can be chopped off, chewed upon and then discarded on rich subtropical soil, and it grows back right there. Sugarcane stalks serve as seeds, and on average, a cane field is replanted every six years.

Sugar is produced from two main sources: sugarcane and beets. Sugarcane was the first source of sugar, and today approximately 80% of the world’s sugar is still produced from sugarcane, while the remaining 20% comes from beets. It is also worth noting that the 10 largest sugar producing countries represent roughly 75% of the world sugar production, with Brazil and India combined producing 50%. And, the 10 largest sugar consuming countries represent roughly 65% of total world consumption, with India and the European Union composing about 35%.

Sugar pricing exhibits some distinctive pecuniary characteristics. Since the colonial days, global sugar trade has been influenced by constant government intervention, either via production subsidies to farmers, import restrictions, imposition of tariffs or trade blocs. As you can imagine, that undoubtedly has a significant impact on the market price of sugar. Even in this modern day of free markets, these subsidies are still in place. That’s because as much as 70% to 80% of all sugar produced is consumed in its country of origin.

That said, sugar is traded freely in a competitive marketplace. The most liquid exchange-traded instruments available to trade this commodity are futures and options. Sugar is traded on futures exchanges as either raw or white sugar futures. The refined, white sugar futures (No. 407) contract trades in the United Kingdom on Liffe (in units of USD/tonne) and the more liquid, raw sugar futures (No. 11) contract trades on the ICE U.S. Exchange (in units of cents per lb.) in the United States. There are a few exchange-traded funds/notes listed for sugar, but they have precious little liquidity.

Sugar presents a convincing investment theme, and the futures market attracts momentous trade activity to command the action of market participants, making sugar futures an ideal instrument for traders looking to make a sweet profit.

Trading sugar

Broadly speaking, futures can be traded either outright or in the form of spreads.

When trading outright futures, the reward is high, but so is the risk. On the other hand, when trading a spread, because you are buying one contract and selling another in the same or related commodity, ideally you make more money on one contract than you lose on the other. Your profit potential is limited, but so is the relative risk.

Traders largely choose their strategy based on market prices/conditions, hedging/risk management needs, directional views, risk appetite, and sometimes they just have a preference for a particular trading style. For many, spread trading offers the most effective alternative.

Spreads: Timing matters

Let’s look at a short calendar spread. In this case, we’ll short a near-term futures contract and go long the deferred month. With this position, we stand to gain when the spread widens (that is, when the near-term futures declines, and the deferred month futures contract rises in price), and lose when the spread tightens.

In trying to identify calendar spread opportunities, we study “Spreading sugar” (below). Historically, when sugar prices are high, we notice that the futures appear to trade in backwardation; the front month trading higher than the deferred month. Conversely, when prices are low, futures seem to trade in contango; the deferred month priced higher than the front month. Additionally, the calendar spread between the front month and the deferred month shows a long-term mean-reverting nature.

Before we put on the trade, we need to consider our conviction that the pattern will persist. Do we expect the gap to close or widen further? If our analysis indicates a strong mean-reverting signal, then during a period of high prices, we can execute a profitable trading strategy by buying the front-month contract and selling the deferred. In this example, within a few days, we hope to extract enough profit from this spread before the pendulum swings in the other direction.

Buying the dips

For a spread trader, sugar also presents another interesting opportunity. Given the high correlation between white and raw sugar futures, we can execute a spread on the premium of refined over raw. We sell the white and buy the raw if we expect the spread to tighten, and vice versa if we expect the spread to widen.

A quick analysis of the charts indicates that this spread tends to cluster in a tight range, and when there is a price regime change of the underlying futures, the spread begins to cluster narrowly in the new range (see “White over raw,” below).

Trading this spread can be tricky because each of these futures expire on different days, and their available contract months do not always coincide (white futures listing: March, May, August, October and December; raw futures listing: March, May, July and October). Also, from a liquidity perspective, the historical average daily volume and open interest in the front-month contract of the white sugar is about one-tenth that of the raw futures contract.

A savvy trader knows that liquidity constraints will lead to a wider bid-offer spread and slippage in executing both the legs of the spread trade can sometimes be challenging. Given that, profitable trading opportunities with this spread are few and far between, but when such an opportunity does arise, you should take into account the above factors and size your position accordingly.

Directional trading

From a technical perspective, we can look at the daily moving averages to identify the sugar trend. 

We used a 30-day MA, 50-day MA and 100-day MA on a sugar chart. By mid-November 2012, the 30-day MA was below the 50-day MA, and the front-month futures prices had crossed below all three MAs, serving as a strong technical indicator that a correction was due in the downward direction.

From a fundamental perspective, subtle clues concerning the export and consumption of sugar, in addition to weather patterns, must be carefully watched to determine the market’s direction. In this example, selling the front month futures at that time would have been a short and sweet deal.

Seasonal patterns

Given that sugarcane is an agricultural commodity and is harvested during certain times of the year, let’s analyze if this sweet commodity sticks to a seasonal pattern and lends itself to predictable market movements. Perhaps a sugar trader can make an educated play around peak harvest seasons and monetize on seasonal trends.

We know that Brazil is a major player in this commodity, so let’s focus on that country’s major producing region — south central Brazil. The main harvest season there runs from May through October, so it might be realistic to presume that prices typically bottom out around April/May and spike in the subsequent months as peak harvest season begins.

Taking the settlement prices of the front-month contracts and the next-month contract, we notice that historically the seasonal trend is not really consistent (see “Seasonal shifts,” below). Sometimes, there is a trending behavior, while other periods prices are range bound. A concern over lower output (driven largely by weather, etc.) would have caused a trending market. However, its effect could be counteracted by high inventory and low demand due to various macro factors. A smaller buffer between total supplies and demand can cause many traders to sit on the edge, and that sets the stage for tight, range-bound prices.

From a pattern study perspective, a sugar trader should also monitor the forex market. Sugar is priced in U.S. dollars, so the Brazilian real/dollar exchange rate can impact the pricing dynamics.

Because cane juice is used to produce both sugar and ethanol, when market prices of sugar are low, it becomes profitable for producers in Brazil to use sugarcane to make ethanol instead of raw sugar. So, a savvy sugar trader should also keep an eye on the ethanol parity.

The market’s obscurity often conceals genuine trades, but an astute player with a solid understanding of the fundamental machinery of markets will always seek out and identify profitable trading opportunities in any market environment.

Bani Arora is a derivatives trader and can be reached at baniarora@hotmail.com.

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