Try This Corn/Wheat Spread Trade

07/22/2011 9:00 am EST

Focus: COMMODITIES

Andy Waldock

Founder, Commodity & Derivative Advisors

Unusual action in the agricultural commodity markets has given way to an opportunity whereby traders can profit by selling corn at a higher price than wheat.

There are prices we accept in life as absolutes. We accept that gold is more expensive than silver or that a Mercedes is more than a Chevrolet. But sometimes, things change.

Remember when diesel fuel was cheaper than gasoline? Not only is diesel more expensive, it has maintained its premium for more than ten years now. Recently, another market relationship has been called into question—the relationship between corn and wheat.

Historically, wheat futures trade at a premium to corn futures. In fact, over the last 40 years, there are only about ten periods where corn closed at a higher price than wheat. Going through 15,000 days worth of data, I found that there were a total of 56 trading sessions that corn closed at a higher price than wheat. This is .0037% of the time. Nineteen of these closes have occurred this year and 15 came in 1984. There have been no instances of this for more than 25 years.

The typical eyeball range for the spread is around $1.50. Wheat is normally worth about $1.50 more per bushel than corn. The widest this spread has been is $7.15 in March 2008. The recent peak was in August of last year at $3.82.

Conversely, when this spread has gone the other way, as it is currently sitting, the widest we’ve seen it was corn trading $.40 cents over wheat last month.

See video: Wheat/Corn Spread Trade Is on Now

I went back through the USDA Acreage and Crop Production reports from the periods when this spread went negative and found some similarities between 1984 and 2011. The carry-out stocks for the new crop years were exceptionally tight in both cases. The carry-out stocks at the end of the 1983 crop year were lower due to two factors.

First of all, fewer acres were planted in 1983 due to governmentally implemented acreage reduction programs following record production in 1982. Secondly, crops in 1984 experienced severe drought conditions, which led to the second smallest harvest in history. In fact, the 1984 harvest ended up being 49% lower than that in 1983.

We started 2011 back at the same record low stocks-to-usage ratio we were at 25 years ago. This year, the governmentally sponsored ethanol production intends to take 40% of the 2011 crop off of the market, and we have had lousy planting weather on top of that. Combining governmentally driven demand and lousy weather, we begin to see the similarities between the 1984 and 2011 crop years.

The corn and wheat contracts for September delivery are still trading back and forth of even money. The trading idea is to sell corn at a higher price than we buy wheat. This strategy will profit as these two markets return to a more normal trading relationship and wheat begins to rebuild its premium over corn. This spread has recently traded as far as $.33 cents towards corn over wheat at the end of June. The highest it has been is $.40.

Calculating the trade on a cash basis, we can determine our trading parameters. Forty cents is equal to $2,000 per spread position in risk to a trading account’s value. Conversely, a quick reversion to the spread’s normal range of $1.00 - $1.50 in wheat over corn would equal a cash value of $5,000 to $7,500 in trading account profits per spread position.

However, as with the diesel fuel to regular unleaded example, it’s possible that these market relationships can shift from anomaly to a new normal. Therefore, risk must always be the first consideration when deciding whether or not a trade is suitable for your account.

By Andy Waldock of Commodity & Derivative Advisors

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