As the wheat market struggles to come to terms with tight global supply and extremely high prices, spread trading may provide the best opportunities to profit in volatile markets.

Volatility remains high and 40 to 50 cent daily trading ranges are not uncommon. At these elevated prices, I do not expect the volatility to diminish any time soon. High volatility does provide more opportunity, but it also results in a substantial increase of risk. Trading highly volatile markets can result in situations that do not allow participants adequate opportunities to manage market exposure, and can be more time consuming. Many traders are not suited to handle this risk and in many cases the end result is a disappointing trading experience.

A common misconception is the idea that spread trading has less risk. I am not touting intra-market or inter-market spreads as having less risk. In fact there have been numerous instances of 20 to 25 cent daily trading ranges and many intra-market spreads posted 50 to 60 cent ranges on Thursday. Even though price differentials also experience volatile price movements, the structure of spread strategies does allow more opportunities to manage market exposure.

Spread orders pertain to buying and selling different contract months simultaneously. Intra-market spreads, otherwise known as Inter-delivery spreads, consist of being long and short different contract months in the same market. An example of this would be buying Chicago March at a premium of 1 cent over Chicago May. In this case the market participant believes Chicago March will proceed to trade at an even greater premium to Chicago May. This example is referred to as a bull spread. Selling this spread or bear spreading would result in the exact opposite position or a sale of Chicago March at a 1 cent premium to Chicago May. The previous mentioned strategies are examples and not recommendations.

Like trading futures flat price, how you address spread positions depends on how strongly you feel about potential price action based on fundamental or technical analysis and or gut instinct. People expecting the current rally to continue will look to bull spread the market. Rallies generally generate more support for the front month, most active contract, while deferred contracts are also supported, but to a lesser extent. The exact opposite can generally be said for a down trending market. This is not set in stone, but given the current scenario this is how these spreads should be approached.

Based on current global stocks, the likelihood of wheat staying supported is very strong and the potential for the rally to continue does exist. Previous price breaks, albeit rather shallow in most cases, have created numerous opportunities to profit from bull spreads. I believe these opportunities still exist and will develop once again on the next sell off. It is difficult to choose levels at which to put these spreads on. In my efforts to spread the market I feel more confident basing my decisions off of the higher volume contract. Generally, the front month contracts have more activity, but this not always the case. One key factor to look at is support and resistance levels in this contract. Another key factor in terms of commodities and in this case wheat is the current fundamental situation. Fundamentals may not always have as much influence on commodity prices as many believe they should, but they can have a pretty sizeable influence on price discrepancies between corresponding months. This year is a perfect example. Supplies are short and demand is not only high, but also immediate. This creates a situation that requires heavy front month buying. The Mpls Dec/Mar spread experienced a sizeable inverse as users of Spring Wheat attempted to cover immediate demand. The Mpls Mar/May spread is following the same pattern. Eventually, new crop supplies will ease some of the supply concerns, but Spring Wheat harvest will not begin until late summer.

Inter-market spreads, otherwise know as Inter-commodity spreads, consists of having long and short legs that are in two different commodity markets. Usually these commodities are closely related. A couple examples of this type of trade are; buying/selling Mpls May against a sell/buy of Chicago May. The trade results in a long and a short position. Each position is in a different commodity market.

These positions allow market participants to take advantage of price discrepancies between the different classes of wheat and wheat/corn. At times a particular class of wheat can trade at a sizeable price discrepancy to the other wheat markets. Again the positions do carry risk. The Chicago Dec/Mpls Dec spread had a trading range of approximately $1.80 cents in a short period of time. When determining where to enter or exit inter-market spread positions I begin by looking at the same key factors I outlined for intra-market spreads. However, in this case I may put more emphasis on fundamental factors. The three major classes of wheat, SRW, HRW and HRS, have distinct qualities and characteristics that affect the value of the commodity in the global and domestic marketplace. Additionally, these commodities are generally grown in different areas, which experience different weather patterns and different growing seasons. All of these factors are prominent when trying to determine fair value of not only the individual wheat class, but also the value of one class of wheat in comparison to the other classes.

While all global wheat stocks are in limited supply, concerns over the limited amount of available HRS continue to develop. The USDA estimated HRS ending stocks at 87 million bushels, which is down considerably from last year and near record lows. Additionally, the HRS new crop will not be harvested until late summer, which adds to the growing concern. This situation may allow intra-market spread traders an opportunity to take advantage of strength in Mpls. If the market trends lower, the potential of Mpls have more support than the other wheat markets does exist. In the event the market rallies from current levels a lack of selling based on current short supply may allow HRS to experience further gains. I would be very careful being short HRW, Hard Red Winter Wheat, in this situation because that crop is also in very short supply and the new crop has experienced some dry conditions.

Like flat price trading use these strategies with caution. The current market scenarios have a tendency to change quickly.

Do you have a question about this article? For a personal response within 24 hours, please email Brian.Henry@archerfinancials.com

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