Martin Kronicle

Continuing from yesterday’s post, today we’ll look at the CBOT wheat / CBOT corn spread. Right now, the December corn contract is trading near a $2.00 discount to wheat. If you think corn will appreciate faster than wheat and invert like the May (K) contracts have, you can go long corn and sell wheat against it.

Trading rule / warning: trade only 1 spread if your normal contract position size is 1 contract. Don’t over-leverage your account because you see the potential for $10,000 potential profit per spread by December or because you’re afforded lower spreader margin. That can become deadly very fast and you can lose money on both legs – both can go against you.

You trade this at your own risk and this is not a trading recommendation.

There have been a couple of write-ups about corn and wheat being “at parity” since they are at the same price. The articles are speaking about the May (K) contracts for both.

This phenomena is irrelevant. What is compelling about comparing wheat to corn is the protein content. Each has a different % protein composition. The CBOT wheat has about 11% protein and CBOT corn has about 8%. (FYI – the KCBOT wheat has the highest percent protein, but that’s not the one being compared. It’s also a different grade of wheat.)

You might not care about protein content of these commodities, but the feedlotters do. Kansas wheat is used for breads, and CBOT wheat is used for making cookies and crackers. They are different grades of wheat and cannot be delivered against each other. Most wheat is used to make flour, but some of it can be substituted into cattle feed. Corn has several uses, such as ethanol production, corn meal, but mostly it is used for sweetener.

(click for larger and clearer chart)

Wheat is a carry-charge market right now (see calendar above). That means that each successive month in the calendar has a higher price than the previous. The difference is what’s called “the carry.” What the market is saying in a carry-charge market is that “we will pay you more later in the year if you store your wheat than we will at today’s prices.”

(click for larger and clearer chart)

Corn (above) on the other hand, is a market in backwardation: it is inverted. The prices for the near months are higher than the deferred months. This market penalizes storage. “We will pay you top dollar for your corn right now, and pay you much less if you decide to store you corn.”

At the same price, you’re getting less protein in corn than if you bought wheat. At least for the May (K) contracts. In this regards, corn is not as valuable as wheat, as some suggest.

What will happen to the deferred months if the demand for corn increases or an increase in acreage does not allay the concerns for tight supplies in corn?

Tomorrow I’ll show you how a spread look between wheat and corn. These types of spreads are called inter-commodity spreads because they are two different commodities in the spread.

“When you are in a boat that springs a leak, you don’t drill another hole to let the water out.” – Tony Saliba, from Market Wizards

I read a blog post a few months ago about how to deploy an options “repair strategy” on a commodity futures position that was losing money. I don’t think the author had any clue about what trading is about. He called it a band-aid strategy. It occurred to me that the whole article was written to help his clients (and probably the author) avoid the feelings around taking losses.

There are no band-aids in commodity trading. Although written with extreme detail on how to overlay a few options to an existing outright position that was losing money, I would not try fix a position by adding other options or futures contracts.

The Best Ideas Are Simple

The best ideas are very simple to understand and simple to execute. If you have a losing position, get out when you start losing money. Adding an option to a commodity futures trade creates drama. What happens when your new “synthetic position” starts losing money? What will you reach for then?

If you have a losing commodity futures position, don’t try to create a spread by buying or selling a deferred contract. This creates drama too. Unless you are familiar with spreads, it will also create more drama. How do you know that the spread is not trading near full-carry?

If you have a losing position, get out of it. You will be able to see more clearly and without emotion while you don’t have the position still going against you. By doing so, you won’t waste valuable mental energy on a losing position. You will cut the opportunity cost by getting out of the loser and finding another trade. Most importantly, you will conserve your capital.

Don’t bring band-aids to the trading desk. Leave them at home. This goes for systems traders and investors also.

Historic highs tell you a great deal about the fundamentals of a commodity, in this case corn. How many traders are calling a top and selling this market short? Guess where they are putting their protective Buy Stop orders? Yes, at new highs, so you have short-covering buying pressure at those levels.

Compounding the idiocy of selling historic highs short, as price points they are also important as they represent any “X-Day” high in your system. Whatever that day is, the historic high price point is that price also. Therefore, you’re likely to see new longs enter at those prices too. That’s how markets go parabolic: the shorts are bleeding out of their a**es and the new longs are entering the market.

Historic highs also show you how horrible analysts and talking heads are about making predictions. Trends persist, and those with historic highs can go on for a long time and have several parabolic spikes during the moves.

For more on predictions, you can read Expert Political Judgment: How Good Is It? How Can We Know?. It is one of the most insightful books you can read about human behavior around making predictions.

Here is what Louis Menand from the New Yorker had to say. Most of the reviews echoed his sentiment:

“It is the somewhat gratifying lesson of Philip Tetlock’s new book . . . that people who make prediction their business–people who appear as experts on television, get quoted in newspaper articles, advise governments and businesses, and participate in punditry roundtables–are no better than the rest of us. When they’re wrong, they’re rarely held accountable, and they rarely admit it, either. . . . It would be nice if there were fewer partisans on television disguised as “analysts” and “experts”. . . . But the best lesson of Tetlock’s book may be the one that he seems most reluctant to draw: Think for yourself.”

The April class will be getting into the ton of material I have online this week. What are you waiting for? Are you waiting to buy your 95th “How To Trade…” book to complete your education?

Evolve into a trader.