One offshoot from the extreme volatility that came with the GFC is that many private traders are now looking beyond the simple strategies such as buying shares. While all traders are still looking for healthy returns there is also a greater awareness of risk.
Trading in futures and FX have been placed at the risky end of the scale mostly, if not completely, given the leverage factor. However there are strategies that offer a reduced risk profile while maintaining excellent profit opportunities.
Enter ‘spread trading’. Futures spread trading has been around for a long time, but it is gaining popularity among the smaller traders looking for something new.
A lot has been written on the basic definitions of spread trading, so here we’ll only offer a 10 second definition (below). This article takes things one step further and looks at what is called the soybean ‘crush’ spread.
The 10 Second Definition
Futures spread trading involves the buying and selling related contracts simultaneously in an effort to profit from a change in the price differential. An intra-commodity spread involves going long in one expiry month and short in another in the same – long December Corn and short March Corn for example. An inter-commodity spread involves going long in one market and short in another: Long Corn and short Wheat for example.
What is the Crush Spread?
Crushing is the process applied to raw soybeans to derive soybean oil and soybean meal. Think of squeezing a hand full of soybeans. What drips out is the oil and what is left in your palm is the meal. A crude example, but you get the idea.
On the CBOT we have the three contracts available: Soybeans, Soybean Meal and Soybean Oil.
Soybeans by themselves do not have a lot of use. Soy meal on the other hand is used as a source of high protein livestock feed. Soy oil has industrial and food uses. It is the difference in usages between these three contracts that creates fluctuations in the spread and hence the trading opportunity.
Most discussions on futures spreads involve two parts or “legs”: a long side and a short side. The crush spread on the other hand involves positions in all three soy contracts. It’s just that little bit more complex, but easy to understand when you break it down.
The crush spread involves buying soybeans and selling its products: oil and meal. Think of this one from the point of view of a processor or ‘crusher’. The crusher will buy physical soybeans, crush them, and then sell the meal and the oil in order to make a profit. The whole idea is the price of the meal and oil will be greater than the price of the raw beans. That’s what is called a profit margin!
The reverse crush spread is just the opposite of the crush spread. It involves buying the products – the meal and oil futures – and selling bean futures.
Calculating the Spread
Calculating the spread price is a little tricky given soybeans are quoted in cents per bushel; meal is in dollars per ton; and oil is in cents per pound. The conventional method is to convert everything into cents per bushel.
The following table shows the process along with conversion factors.
|Contract||Price (P)||Conversion factor (C)||Converted price (=P*C)|
Think of the 79.11 cents per bushel as the profit margin for a crusher.
There is no need to go too deeply into this calculation as there is one already done for you. In eSignal, the code is BCX followed by the month & year codes. The December spread therefore is BCX Z9. While this is a futures code, it does not actually trade as a standalone contract. To initiate the spread, you still need to transact in the three contracts.
The poor man’s spread is simply a 1:1:1 ratio. A crush spread would therefore involve going long one soybean contract, short one meal contract and short one oil contract. The proper ratio however is 11:9:10. That is 11 soy meal, 9 oil and 10 soybean contracts. The margin discount for this ratio is significant 90%.
Trading the Spread
The laws of supply and demand act to keep this spread within a rough upper and lower limit. At the lower end, if the spread price gets too low, crushers tend to slow production thereby seeing a drop in demand for beans and less supply of the processed products. This supports and/or widens the spread.
At a higher spread price, increased crushing activity means stronger demand for beans and greater supply for meal and oil. This works to narrow the spread. Naturally speculative interest also helps keep the spread within a range.
Overall, this makes for a good market to trade using relatively simple technical analysis. Things such as oscillator divergences at extreme spread values can offer relatively low risk spread trades. The two Stochastic divergences shown are good examples.
There are fundamental differences in the underlying products. That is, the supply and demand factors are different for each soybean, meal and oil. For the fundamental trader, it is essential to understand these differences to understand the spread.
These differences also work to create tradable seasonal variations in the spread. In fact this year’s Nov/Dec crush spread (SX9, SMZ9 and BOZ9) followed the 15yr seasonal pattern very closely. The same can be said for the Nov/Oct spread (SX9, SMV9 and BOV9).
The seasonal influences along with what is a spread than does not have the volatility (risk) of the underlying contracts make it a good instrument to trade in longer term positions.