This article is the second in our series covering multi leg complex spreads fundamentals. The first article focused on intra commodity spreads (Butterfly, Double Butterfly, Condor). The third article will finish with Crack spread and summary.
The most popular inter commodity spreads involve the simultaneous execution of multiple futures positions designed to replicate the inputs and outputs of several real world product transformations or to hedge that production process by putting on the opposite spread. Examples of these are Crush and Crack spreads.
The crush expression is taken from the soybean processing term for buying soybeans, crushing them and selling the resulting soymeal and soybean oil. In the Soybean Crush, a raw material input soybeans (S) is processed into output products soybean meal (SM) and oil (BO).
In the cash market, a 60-pound bag of soybeans can be crushed into 11 pounds of soybean oil, 44 pounds of 48 percent protein soybean meal, three pounds of hulls, and one pound of waste. The gross processing margin (GPM) allows producers to compare the input cost of beans with the output revenues of bean products.
To get correct expression for GPM we need to do some calculations as the quantities are given in different units of mass, volume and price:
Knowing the conversion ratios, we can put together margin expression:
GMP = -S+SM*2.2 +BO*11
CME Exchange uses GMP to calculate Soybeans Crush Index (BCX) which can’t be traded directly, but is the underlying for options. For futures trading we can use Board Crush which is GPM calculation when applied to the soybean futures product complex traded on the CME. Board Crush can be traded as “mini-size” in 1:1:1 (-SU14+SMU14+BOU14) ratio or more precise version 10:11:9 (-10*SU14+11*SMU14+9*BOU14).
SeasonAlgo will automatically calculate these spreads as Equity spreads (each leg is multiplied by its point value).
A soybean processor concerned about rising input costs can go long soybeans and short soybeans meal and oil. If soybean price rises, the higher purchasing costs are offset with a gain on the soybean futures. On the other way a decline in the price of soybean meal or oil that reduces processor’s revenues is offset by gains on the short futures positions. When the price of soybeans rises relative to the price of bean meal and oil, GPM can sometimes become negative and processors can stop their production or they can enter reverse Crush hedge consisting of short soybean and long soybeans oil and meal that restores the viability of processing even during periods of negative GPM. Reverse Crush is also called synthetic processing because the positions in the futures replicate rather than hedge the processor’s cash market position.
When trading Soybean Crush, watch for divergence between the products. Processors are trying to maintain their margins despite of changing market conditions and trends. If spread is narrow, the profit potential inclines in the direction of soybean meal and oil contracts (cost to process soybeans is too high to produce any reasonable profit). If spread is widening, processors push to sell soybean meal and oil to realize their profits. This push usually promises that the product prices will be forced down to converge with soybean prices.
A similar process exists in cattle feeding, but it differs in that multiple inputs are transformed into a single output. Feedlot operators buy feeder calves and feed to start the process then, after a period of time, sell finished cattle ready for slaughter. Cattle Crush (or also called Cattle Feeding Spread) involves buying feeder cattle (FC) futures and corn futures (C), and selling live cattle (LC) futures. Cattle Crush models the economics of the feedlot operation and provides a way to estimate profitability and manage margin risk. And of course offers profit opportunities for traders.
The difference between the purchased input value and the sold finished cattle value is called the gross feeding margin (GFM). Different numbers of each contract are necessary to balance Crush properly. Because feeder cattle contract covers about 66 animals (50 000 pounds per contract divided by an average 750 pound feeder calf) and live cattle contract only covers about 32 animals (40 000 pounds per contract divided by an average 1250 pound steer), the number of live cattle contracts must be doubled.
The precise amount of corn needed for cattle feeder to achieve its weight gain is influenced by many factors, so for simplicity's sake we will take an average value 2650 bushels. The price risk can be managed by one corn futures contract of 5 000 bushels resulting in 1:1:2 ratio. However, that will result in over-hedging. Commercial hedgers have to determine the number of contracts to trade based on feedlot characteristics to achieve closest hedge. For example they can use mini-sized corn contracts or different ratios (2:4:8, 2:3:6, 3:5:10). Speculators trading Cattle Crush may use different criteria as they don’t need perfect hedge and can accept and manage risk. With 2:1:1 ratio speculator may realize this combination of futures contracts creates more risk from corn price movements than is likely to exist in feeding physical cattle and accept it.
Beside the number of contract, equally important is the arrangement of the contract months. Feeder cattle contract should be four to six months earlier than live cattle contract. This represents the amount of time required to feed an animal to slaughter weight. The contract month for Corn typically falls between the Feeder Cattle and Live Cattle contract months. This is done to represent the average cost of corn for the duration of the feeding period. When you use SeasonAlgo Wizard to load predefined Cattle Crush spread, contract months will be automatically correctly chosen and spread is calculated as Equity spread. Our spread definition follows input-output and contract’s expiration order. Example Cattle Crush spread can be -FCU14-CZ14+2*LCG15. Rationale behind the speculation on Cattle Crush is very similar as on Soybean Crush.
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The risk of loss in trading commodities can be substantial. You should therefore carefully consider whether such trading is suitable for you in light of your financial condition. The high degree of leverage that is often obtainable in commodity trading can work against you as well for you. The use of leverage can lead to large losses as well as gains. Past results are not indicative of future results. Hypothetical performance results have many inherent limitations, some of which are described below. No representation is being made that any account will or is likely to achieve profits or losses similar to those shown. In fact, there are sharp differences between hypothetical performance results and the actual results subsequently achieved by any particular trading program. One of the limitations of hypothetical performance results is that they are generally prepared with the benefit of hindsight.
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