By Jason Pearce
Did the Fall Finish in Autumn?
Decent autumn harvest weather and large US crops caused soybeans, corn, and wheat to drop from their summer peaks into new contract lows for 2015. In the case of beans and wheat, the futures markets traded to their lowest prices in several years.
Now that the dust has settled, the grain markets have somewhat stabilized. For the most part, they have been confined to trading ranges for the last few weeks. Perhaps the barn-busting 2015 crops are now factored into the market prices. There’s reason to believe that things could start moving again soon, though.
Gearing Up For Action
The wheat market may be the one to start moving as new fundamentals develop. The reason is because wheat actually gets planted twice a year in the US. The spring wheat crop was just harvested. Now US farmers are planting the winter wheat crop. This is the crop that will be harvested next the spring.
Not only does the new crop plantings mean that wheat could start trending again, but it also means that inter-market grain spreads could see some increased trading activity as well. This may provide informed traders with an opportunity in the soybean/wheat spread. If you are not familiar with this one, read on.
Birds of a Feather
Despite the fact that beans have only one crop per year in the US and wheat has two crops, the price trends in the two markets are highly correlated. This is not a new development, either. One can look at nearly half a century of monthly closing prices and see that beans and wheat often peak and bottom at or near the same time.
Of course, there are exceptions to this observation. But the exceptions have always proven temporary. This means two things: First, the strong correlation between soybeans and wheat makes it a tradable spread relationship. Second, the divergence in the price trends between the two markets is likely to be a temporary event and, therefore, an opportunity to get positioned for a bet on the return to the historic correlation.
Historical Spread and Ratio Levels
One way to identify a trading opportunity in a spread is to locate price levels that have historically been extreme events. By that we mean prices that the spread rarely makes it to and prices that have been unsustainable for prolonged periods of time.
In terms of the price difference between beans and wheat, $6.00 (premium beans) appears to be the outlier on the high side and $1.50 (premium beans) appears to be where the rubber band is stretched too far on the low side. Whenever the spread has gone to or beyond these price levels in the past, there has ultimately been a reversal.
Over the last few years, though, we’ve seen the soybean/wheat spread clear six dollars several times. It even hit a new record high in 2013. Part of the reason for this is because the grain markets themselves posted historic highs. When that happens, the spreads reach record highs as well. The record prices can distort the extremes in the relative value between markets. To remedy this, viewing the ratio between the beans and wheat can clarify whether or not the market relationship is historically out of whack.
The 30,000 foot view of the bean/wheat ratio shows that the beans are unsustainably overvalued when the ratio reaches 2.4:1 or higher. Whenever this level has been reached or surpassed, the ratio would ultimately reverse. Conversely, the bean/wheat ratio is undervalued whenever it has dropped below 1.4:1. Prior excursions to this level or lower have all been followed by a major recovery where beans outperformed wheat for months and even years afterwards.
The Value of Seasonal Patterns
The nearest-futures soybean/wheat spread is currently around $3.62 (premium beans). Historically, this is no man’s land. The spread would have to move over two dollars from here in either direction in order to start probing the historical boundaries where a trend reversal setup becomes more favorable.
Furthermore, the current bean/wheat ratio is at 1.7:1. This is uninspiring to the spread trader who scouts out levels in the relationship between beans and wheat where the difference has experienced enough of a divergence to trigger crop rotation, relative value plays, or something fundamental that would act as a catalyst for an eventual reversal.
The absence of an outlier in current price levels does not mean that the hunt for opportunity is off, however. We still have another weapon in our trading arsenal that could serve us well: the seasonal pattern.
A seasonal pattern shows the typical route that a market or a spread follows during the year. This makes perfect sense. After all, we know that grains will be planted in the spring and harvested in the fall every year. And it’s no secret that refiners will switch from producing heating oil to producing gasoline as they anticipate the warming temperatures and the start of the US driving season. Therefore, we have a pretty good idea of what the supply and demand trends for various commodities should be at certain times of the year.
The seasonal pattern is not the Holy Grail of trading. Nothing works all the time in every market. But knowing the seasonal patterns can still give you a very tradable edge. Some markets are more compliant with their seasonal patterns than others, so you really want to pay attention when you find one with a consistent track record. Those should be your weapons of choice. In the case of the soybean/wheat spread, the seasonal pattern might just be the silver bullet that compels us into taking the shot.
Remember, Remember the Fifth of November
Now that the 2015 harvest is over and planting for the 2016 winter wheat crop is in progress, the spring 2016 bean/wheat spread is in our crosshairs. Seasonally, you will be looking to buy the spread this week and sit on it for about two months.
Moore Research Center, Inc. has already done the work on this trade. According to their research, you should buy the May 2016 soybean contract and simultaneously sell the May 2016 wheat contract on November 5th and exit the spread on January 8th. I repeat: Buy the spread on Guy Fawkes Day and hold it through the first full week of the new year.
This seasonal spread trade has worked every single year since 2000. For the mathematically challenged, that’s fifteen consecutive years of winners. Will it work for the sixteenth year in a row? We don’t know. The future is not guaranteed, especially when trading futures. But would you want to bet against something that has worked for a decade and a half straight?! There’s a sign on the wall of a local Irish pub that says, “The race does not always belong to the swiftest nor the battle to the mightiest, but that’s certainly the way to bet”. There’s wisdom in those words. Always bet with the odds.
In addition to the success rate, the payout on the seasonal May soybean/wheat spread has been a respectable +$2,042 in profits (on average). On a 5,000 bushel-per-contract spread, this represents a gain of nearly 41-cents. Since the 2015 price range for the May 2016 bean/wheat spread has been $1.11 so far, 41-cents represents just over one-third of the year’s entire range to date. That’s not an insignificant move.
The plot thickens as the chart pattern on the May 2016 bean/wheat spread indicates that price support may have been established. Technically, this lays the foundation for a move higher.
Depending on how picky you are, one could say that a double bottom-type pattern was established on the daily chart between the December 17, 2014 low of $3.59 1/2 and the September 23, 2015 low of $3.56.
If the three and a half cent difference between the two lows bothers you, we could alternately refer to it as a Wash & Rinse pattern. This occurs when a market undercuts an important price low, sees little or no follow-through, and then quickly reverses higher. The mechanics are such that any sell stops or algorithm sell patterns below the price bottom are initially triggered on the break. The lack of a continued decline indicates that the sellers were suckered in, subsequently forcing them to start buying on the recovery. This is considered a bear trap, which is a bullish pattern.
Furthermore, the May 2016 bean/wheat spread has not been able to close below $3.70 for more than four consecutive sessions. This indicates that demand keeps coming in down around this current level. As a buyer, you want to locate the levels where demand has been consistent and take advantage of it. One you identify this area, you know where to buy. You will also be able to monitor the level for any important changes in the behavior pattern.
Balancing the Probable with the Possible
We discussed the setup and entry/exit parameters for the May 2016 soybean/wheat spread trade. It’s a no-brainer that you want to find seasonal trades with a long track record of success. This indicates that there are strong and consistent underlying fundamentals that drive the spread. It means the odds of bagging a winner on the next go-around are favorable. That’s what trading with the probabilities is all about.
However, your trading plan is not complete until your addressed the possibilities. This is where risk management comes in. You have to determine your position size (how many contracts) before you take the trade. Make sure it is small enough to withstand the inevitable losing streaks that come with the territory. Risk management is the Yin to the Yang of trade selection. Just like the ancient Chinese philosophy, it is complementary to trade selection, not opposed to it.
In the event that the May 2016 bean/wheat spread breaks the current contract low of $3.56, it’s probably time to go on the defensive. Where do you throw in the towel? Will it be on a 10% break of the contract low at $3.20? Will it be on a two or three-day close below the September low? Will you take a close below the September low as a sell signal with a close back above it as a reentry signal? If so, how many trades in a row like this will you take before you have endured enough whipsaw and call it a day? Take inventory of your trading capital, confidence levels, and emotional makeup to determine the answers to these questions. Then get ready to pull the trigger and buy the May bean/wheat spread.
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