Trade War Trading
The winds of a potential trade war have been blowing, and no U.S. sector is as vulnerable to one as agricultural commodities.
By mid-March 2018, rhetoric regarding trade relations between the United States and China began to heat up. President Trump started this earlier in the year with an announcement of steel and aluminum tariffs. Later he focused more on China and Chinese officials responded in kind. The heated-up rhetoric seemed to be capable of starting a serious trade war in which each country would boost tariffs that would raise the cost of the other nation’s exported products.
By April, there was a temporary stand-off; however, if either country increases its tariffs, the other is certain to reciprocate with at least equal force.
Because China imports millions of dollars of American agricultural commodities, these are under greater threat than other U.S. exports. “Agriculture commodities at risk” (below) shows five ag products: Wheat, corn, soybeans, cotton and cattle. Looking at the cumulative percentage price changes of the exchange-traded funds (ETF) associated with each commodity’s July 2018 futures contract, we can see certain qualities that suggest promising trades whether or not an actual trade war develops. While some of the weakness — all but cotton and soybeans are lower than a year ago — could be attributed to the threat of trader barriers, there is an opportunity for movement among the similar commodities.
Included in the five markets in the chart are two pairs of underlying markets that are significantly correlated. Wheat and corn are always worth inspecting because of their long-term tradable relationship as a pair. Wheat is more volatile than corn, causing variations in the distance between their prices that can be exploited for profit. The basis between the two will typically grow and then reverse over time creating spread opportunities.
WEAT and CORN are the ETFs based on the Chicago Board of Trade wheat and corn futures contracts representing price changes for near-term wheat and corn futures. “WEAT – CORN” (below) shows that WEAT, the more volatile member of the pair, might have been bought or sold several times against the opposite trade in CORN, the more stable of the pair.
CATL and SOYB are the ETFs based on the underlying live cattle and soybean futures contracts. In this pair, CATL is the volatile member with the soybean ETF providing the stable background for pairs trading. CATL and SOYB are especially interesting at this time, with a potential trade war between the United States and China as a possibility (see “CATL – SOYB,” below).
Soybeans are a large export crop and any disruption of that market would cause drastic price declines. Therefore, the -15% difference between CATL and SOYB may indicate that soybeans are priced high relative to cattle. The pair might make a profitable trade — buying CATL or cattle futures against a sale of SOYB or soybean futures.
While China imports both soybeans and cattle (beef products) from the United States, it is much more dependent on soybeans, and a trade war would likely have a greater impact on soybeans. China has already moved to import more beans from South America.
Trading choices for taking advantage of pairs that are temporarily out of line include futures, options and ETFs. For the pairs shown on “CATL – SOYB” and “WEAT – CORN” we will start the following trades and follow the resulting profits or losses through the futures expiration date in July 2018.
Based on the charts, the cattle contracts should gain versus soybean contracts, and wheat contracts should gain versus corn contracts. On April 6, 2018, soybeans were overvalued compared to cattle, and corn was overvalued versus wheat.
The starting positions on April 6, 2018 are as follows:
• Buy WEAT at 6.42; sell CORN at 18.05
• Buy July wheat futures at 4.885; sell July corn futures at 3.97
• Buy July wheat 480 calls at 25.125; buy July corn 400 puts at 18.540
• Buy CATL at 6.055; sell SOYB at 18.835
• Buy July cattle futures at 102.775; sell July soybean futures at 10.545
• Buy July 105 cattle calls at 4.000; buy July 1080 soybean puts at 24.625
These trades may be closed out at any date on which the trader believes there has been an adequate profit or an acceptable loss. The trade’s ultimate closing date is July 13, 2018.