by Richard Ilczyszyn

The wild moves in the grains markets can be troublesome for many investors, and one way to cope with this volatility is through a spread strategy. Calendar spreads are popular with professional grain traders, but the strategy can be applied by any trader, in other markets.

Trading grain futures can be tough for both new and experienced traders. Even the best traders get stopped out when the markets make big moves. Volatility can be great for traders, but it can also be problematic. There are many factors that can affect price action that are unpredictable and have little to do with fundamental or technical market factors.

Volatility can be impacted or caused by activity of hedge funds and index funds, as well as daily fluctuations in world currencies. These factors can have a major impact on price action in grain markets in particular. A lot of people don’t have experience trading spreads, but they are worth taking a look at when these types of conditions can occur.

The price movement in spreads is seldom affected by action in world currency markets, and is generally more true to fundamental market factors—basic supply and demand. You can use the strategy whether you are bullish or bearish a particular market, for any reason. If you are bullish, you would buy the closer-dated month contract and sell the deferred month contract. There is a “cost of carry” involved for holding that longer-dated contract. The strategy I will outline is essentially a cost-of-carry spread. You are looking for the differential move between the two contracts.

A huge move in the futures markets (up or down), will likely affect the action of a spread very little, relatively speaking. This is why many grain traders prefer to trade spreads rather than trading outright futures contracts. That doesn’t mean of course this strategy will always make money. You have to keep risk factors and parameters in mind, like any other trade.

Margin Requirements
Margins are more favorable for spread trades versus outright futures positions, which is another reason I like them. The exchanges have acknowledged there is less risk in trading certain spreads than the outright futures contracts. So, it’s less expensive for you to initiate and maintain your position when you trade a spread, and you won’t tie up as much funds as you would with outright futures positions. Please note that the margins listed below are current as of the date of this article, and are subject to change without notice at any time. Commissions and any other costs to trade must also be considered.

Soybean futures margin $3,713 per contract.
Soybean July/November spread margin $1,215 initial/$900 maintenance (five or less)

Corn margin $1,350 per contract
Corn July/December spread margin $270 initial/$200 maintenance (five or less)

Wheat margin $2,025 per contract
Wheat May/December spread margin $270 initial/$200 maintenance (five or less)

The Calendar Spread Defined
A calendar spread in any market involves buying a futures contract in one month, and selling one in a different month. Keep in mind, you can do this type of strategy in a variety of markets, not just in grains, but I’ll use grains as an example as this strategy is particularly popular with grain traders.

A popular calendar spread in the soybean market is the July/November spread. A trader would simultaneously buy the July futures and sell the November futures (or vice versa) in order to take advantage of changes in the relationship between the two contract months. You might see the nearby (in this case July soybeans) contract priced lower than the deferred (November soybeans) contract. However, as we get closer to delivery and contract expiration, this relationship can change. If the market has bottomed and is bullish, you’ll see the July catch up and gain against the November, and surpass it. Your goal is to pocket the difference in this price relationship.

Traders participating in calendar spreads generally care very little about the price of the outright futures, focusing instead on the spread relationship. I don’t want you to think this is a low-risk trade, but in a spread trade, generally one leg will be losing money while one will be gaining, so it’s more stable. In a successful spread, the goal is for gains in one leg to outweigh the loss in the other. This is sometimes a difficult concept for new traders to grasp. You can be on the wrong side of the spread of course, and see it widen against you. So, it’s still very important to manage the position and not just put it on and forget about it.

There are two basic types of spreads, depending on your market opinion—a bull spread and a bear spread.

•    If you are bullish, you buy the nearby and sell the deferred.
•    If you are bearish, you would sell the nearby and buy the deferred.

Trading the Spread

Calendar spreads are generally affected by supply and demand factors rather than money flow or outside influences. Go with the trend. When there is a rather loose supply/demand scenario in grains (times when supplies are sufficient relative to demand), it is not uncommon to find deferred contracts trading well above nearby months.

As mentioned, the difference in the prices is known as the cost of carry. This amount includes cost of insurance, interest and storage of physical grain. It reflects the dollar amount required to “carry” grain from one month to another.

Spreads will not generally trade past the cost of full carry. For example, the cost to store, insure and pay interest on a bushel of corn for one month is about 6.5 cents. Since this is the entire cost required, the spread between July and December corn should not move past -39 cents (6.5 cents x 6 months = 39 cents). If a July/December corn spread is at -39 cents, it would be quoted as being “39 under,” meaning, July is 39 cents under December.

The closer you get to expiration, that premium typically comes out of the market. You can determine what your profit potential could be based on cost of carry, if your market view is correct.

Once the basic concept of the spread is known, traders can begin to perform their own analysis of certain spread markets and identify opportunities. As mentioned, you can apply variations of this strategy in different months than the examples mentioned here, and in different markets. But always take a look at what the charts are telling you too. Use support and resistance to find appropriate entry points.

I happen to be bullish wheat right now; because I feel fundamentals are strong. This market is at 28-year planting lows; we have a lot of soybeans and corn. If the U.S. dollar weakens, this market could really take off. However, I wouldn’t recommend putting on a trade based on that idea alone. I will watch the technicals, and if they support this outlook, then it makes sense to consider initiating a trade. I believe a combination of fundamentals and technicals working together can increase your odds of success.

When trading calendar spreads, it’s also important to keep in mind what the historical relationship has been. Look at the past 20 years and see where the spread has gone seasonally and in situations with similar fundamentals. You should be aware of pricing and moves that might be outside historical norms. The key to this game is being realistic, and patient. Please feel free to contact me with any questions you have on this topic, and to develop more specific strategies based on your risk tolerance and account size.

Richard Ilczyszyn is a Senior Market Strategist with Lind-Waldock and can be reached at 800-605-0095 or via email at rilczyszyn@lind-waldock.com. Follow Richard on Twitter at www.twitter.com/rilczyszyn.

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