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Spread Management

13:09PM Mar 24, 2012

Take advantage of contract month movements

A cash-only selling strategy might be easier for a farmer to manage, but it lacks the benefits of spread management.

By using futures and options, farmers can optimize the relative movement of contract months to their advantage.

The study of spreads compares the relative movement of one month to another month in the same crop year (the first new-crop corn contract month is September). The objective is to pick the month where the price will go down the fastest relative to deferred contracts in a bear market or go up the least in a bull market.

The following example compares a forward cash sale for March 2012 delivery to a sale of the first month of the new crop year (September 2011). Instead of selling the March 2012 at $6.72 in a cash sale, a producer could have sold the September 2011 corn futures contract at $7.03 and held it until the first notice day. (It’s not a good idea to hold futures until delivery month, because of potential market distortions and the no-limit move.)

On the subsequent roll to the December 2011 contract, the position continues to improve because the December breaks faster than the March 2012 contract. In the end, the net position is $7.22.
It is difficult to immediately realize the gain in the spread strategy, because the September 2011 and December 2011 contracts go down faster than the March 2012 contract. For instance, the relative level between the contract months narrows and gets tighter because harvest is approaching and the market is starting to discourage selling inventory for the time being. It signals a halt by giving incentive, or carry, to the market to hold product through the carry that develops between contract months.

Entry and exit. One of the downsides to futures trading is it requires paying commissions and related fees to enter and exit. But the fees are normally small in comparison to the overall posi-tive or negative impact of the strategy.

In the example, a producer could have realized an impressive 44¢ net gain in 2011 if the nearby contract was sold and rolled forward compared with the producer who merely sells the deferred contracts.

Again, in both cases the producer is short; the only difference is in which contract month the producer started.

Is it best to start in the month you plan to eventually deliver inventory or to take a more
aggressive approach and look at the relative difference between the contract months to determine which month to sell?

Please note that this level of gain is exceptionally high by historical standards; but in many years, a 10¢ to 15¢ gain over costs associated with rolling rather than a sit-and-hold plan is not that uncommon.

The September corn contract is currently trading higher than 30¢, which puts it in the top three years of the past 27 years. The odds are in a producer’s favor to gain on the spread strategy again this year. If the crop gets planted this spring in a timely manner, the market will be steadily taking premium out of September compared with the deferred contracts as we move through the season.

By first notice day, the September could actually be trading under the December contract. This implies there is significant potential to improve the cash sale by proper placement of
contract month again for the 2012 marketing season.

Expanding your marketing strategy beyond cash sales and studying market spreads to know which contract month is best to place a short position can have a tremendous impact on your
long-term profits.

pC16 Spread Management Chart