Liberty Maven

Last time, we touched on the basics of commodity spreads and went over the basic example of soybeans (S) and soybean meal (SM), or the “crush spread.” We noted that by tracking their ratio (S/SM), we could identify times when the relationship between these two contracts is out of alignment with the historical relationship, and take advantage by buying the undervalued contract and simultaneously selling the overvalued.

An important question is: how much do we buy and sell? The obvious (and easiest) answer is to buy one contract of the undervalued commodity, and sell one contract of the overvalued. However, each commodity gives the owner power over a certain number of the commodity – one soybean contract controls 5,000 bushels, for example – and the values of these contracts might be different.

To give an example, let’s look at the soybean / soybean meal spread that we were looking at before. As the chart showed, the ratio of 3.631 looks lower than usual, meaning that soybeans are undervalued and soy meal is overvalued. A $1 move in the contract price of soybeans is a move of $50 in actual value; a $1 move in the contract price of soybean meal is a move of $100 in actual value. These can be calculated from the screen captures above – on the left is the “tick” size for soybeans, and on the right is the “tick” size for soy meal. As the ratio suggests, the two typically trade at a ratio of (roughly) 4 to 1 – that is, the price of the soybean contract will move 4 times as much as that of the soy meal contract. Let’s assume that tomorrow, the soybean contract moves up $4, and the soy meal contract moves up $1, in accordance with this ratio.

1 Soybean contract (SQ8): +$4 = +$200 actual value (since $1 move = $50 actual value)
1 Soybean Meal contract (SMQ8): +$1 = +$100 actual value (since $1 move = $100 actual value)

The goal of the ratio is to have offsetting positions that are roughly equal. If we were to execute this spread using one contract each, we would have twice as much value in the soybean contract as we would in the soybean meal contract. This means that we would be biased towards the soybeans, and if we were buying soybeans and selling soy meal, we would lose money if both were to drop in value, since the gains made in selling the soy meal contract would not offset the losses from buying soybeans. Thus, to make our positions offset (also referred to as creating a “zero-delta” position), we would want to buy one soybean contract, while selling two soy meal contracts.

So we now know that one potential mistake in trading a commodity spread is in trading contracts with different values. Another mistake that is easy to make is not giving yourself enough time for the relationship to come back into balance.

For those unfamiliar with futures contracts, contracts have expiration dates. Typically, multiple contracts, each with different expiration months, will be traded on the same commodity at the same time. The image below shows a “futures chain” or a series of contracts on the same commodity (in this case, soybeans) for various expiration months.

Contract symbols are constructed with the commodity symbol first (S for soybeans, in this case), then the letter corresponding to the expiration month, and then the number corresponding to the expiration year. Specific dates of expiration vary from one commodity to the next.

The lesson here is that it may take as long as two to three months for the ratio between the two commodities to return to your target value. If we were to execute this trade today, it would not be wise to use the August contracts, which will expire in 9 days. In this case, we would be forced out of our position, and would incur any losses that we may have accumulated by a temporary continuation of the trend away from the mean. A better choice might be the November contracts, to ensure that the correction will occur before the contracts expire.

Finally, as with any investment, it is important to set a goal for your trade, as well as a level where you will cut losses and move on. For example, “I will exit the position at a ratio of 3.75, and cut my losses at 3.55.” Set these boundaries for yourself before you enter the position – this will help you to avoid being emotionally attached to your investment, falling into a loss that your portfolio can’t afford, or missing out on a profit-taking opportunity.

You now know the basics of trading commodity spreads: buying the undervalued commodity and selling the overvalued, making sure that the positions are off equal value (offsetting), buying contracts with expiration dates that give you enough time to profit, and setting goals and limits. But why is the commodity spread a good play? Next time, I’ll introduce the many advantages of commodity spreads, particularly in volatile and uncertain market conditions such as those we face today.

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Matt Malkus is a statistics major at Virginia Tech entering his senior year, with more than 5 years of experience in equities markets, and has recently entered into the world of futures markets. He currently serves as the Chief Information Officer of the school’s Society of Individual Investors.

Positions in this article are the opinions of the author and guarantee no future gains. As always, investors are advised to take on only the amount of risk that their portfolio can comfortably handle.