Some softs spread better than others

December 28, 2015 01:00 PM

Soft futures include commodities that are grown and considered semi-tropical: Sugar, orange juice, cocoa and coffee, along with cotton and lumber because of their beginning as plants/trees.

Other would-be soft commodities such as corn, wheat and soybeans or cattle and hogs, are classified as grains and meats. These are traded as groups because of similar markets and uses. Hard commodities include those that are mined or extracted; metals and energies, for example.

Because they do not have common production costs or markets, soft futures and options usually are not candidates for spread trades with other softs. Just because one soft is temporarily high in price and another soft is priced lower does not mean that their prices will necessarily converge. However, a study of recent price pattern reveals opportunities in the space. “Soft futures” (below) shows cumulative percentage price changes from June through September 2015. 

Orange juice & sugar

From June 1, 2015 to Aug. 5, the price of November 2015 orange juice increased by 15.22% while October sugar declined 15.29%. Orange juice and sugar futures usually do not have high volatility; thus, the two diverging price changes offered an opportunity to spread trade on the basis of expected return to normal volatility. 

The result of the spread trade selling November orange juice and buying October sugar on Aug. 5 was that the orange juice contract fell from $131.20 per lb. to $105.55 per lb. (Aug. 5 to Sept. 20), while October sugar increased from 10.82¢ per lb. to 12.87¢ per lb. The size of one orange juice contract is 15,000 pounds with one futures unit is valued at $150. One Sugar #11 futures contract controls 112,000 pounds and one futures unit equals $1,120. 

Risk of adverse price changes in the orange juice/sugar trade could have been offset by an orange juice call and a sugar put. Other considerations such as seasonality of agricultural commodities would have been included in the decision. Alternatively, an orange juice put might have been spread against a sugar call put. 

The other four soft futures contracts are summarized as 10 metric tonnes of cocoa at $10 per futures unit, 110,000 board feet of lumber at $110 for each futures unit, 37,500 pounds of coffee at $375 per futures unit and 50,000 pounds of cotton at $500 for each futures unit.

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About the Author

Paul Cretien is an investment analyst and financial case writer. His e-mail is PaulDCretien@aol.com.