Commodities are all the rage. Energy, metals, food ... if it's a commodity, we need to buy it, right? Indeed, we like to find trading vehicles that are not correlated to the stock market. We do this to diversify away from broad market risk, and to identify low-risk / high-probability short-term trades.
However, we also recognize that you must understand what it is you are trading in order to avoid unpleasant surprises. While we like the grain commodities, as occasional futures traders we realize that blending a basket of grain or other commodity futures into a fund doesn't necessarily provide a rationally or predictably behaving trading vehicle.
For example, if a fund has both soybeans and wheat, with beans on a tear and wheat in the dumper, what will the effect be on the performance of the fund? As well, articles have been written about the effects of contango on ETF performance and we need not belabor that here. Even a single commodity fund may not actually be what it appears unless you carefully examine its components.
a weighted average of daily changes in the closing settlement prices of (1) the second-to-expire Corn Futures Contract traded on the CBOT, weighted 35%, (2) the third-to-expire CBOT Corn Futures Contract, weighted 30%, and (3) the CBOT Corn Futures Contract expiring in the December following the expiration month of third-to-expire contract, weighted 35%.
But what does this really mean in practical application? In accordance with the above description, today the CORN fund is invested in long corn futures contracts for the months of July, September; and December 2011. Before the May contract expires on Friday the 13th, the fund will roll its long contracts to the months of: September, December 2011 and December 2012.
On its face, it is pretty straightforward, but does everyone understand what this means? We doubt it. Corn futures are traded in “old crop” and “new crop” months of December, March, May, July and September. Corn's marketing year runs from October through September; when you think about when corn is harvested, that makes logical sense. Therefore, the “new crop” for corn is first traded in the December contract. This information is generally available at the CME website, the exchange where corn and other grains are traded.
If you think about it for just a minute, you'll quickly realize that the corn that is presently being traded in the May, July, and September contracts was harvested last fall. It's already in the silos, so what we are talking about with the “old crop” is certainty of supply. On the other hand, the corn that is represented by the December 2011 contract is only just now being planted; and the corn that is represented by the December 2012 contract is a full year away from being planted.
So within the next 45 days or so, the nature and trading characteristics of the CORN fund will change considerably. It will go from a fund that is speculating in two corn crop years to one that speculates in three corn crop years. At the end of July, the fund will again revert to two crop years when it trades December 2011, March 2012 and December 2012. Also at that time, none of those crop months will represent any corn that has already been harvested.
The practical effect on a fund like CORN may be further complicated by a commodity futures trading style that we specialize in known as “spread trading.” A futures spread trade is the simultaneous purchase and sale of two different futures contracts whose object it is to profit from a change in the relationship in price between the two contracts. In essence, it is a form of hedging.
Often, a change in the price relationship between two different contract months in the same commodity depends upon seasonal factors, and the trade can be quite profitable. While the reasons that commodity producers, distributors, professional traders and speculators enter into spread trades is beyond the scope of this article, one popular seasonal corn spread is long December (new crop) and short September (old crop) between the months of May and August. Whereas the CORN fund will be long in both September and December contracts between May and July, the seasonal spreading phenomenon may conceivably act as a drag on fund performance during that period.
So is it a bad idea to trade CORN? Not at all. However, it is important to fully understand the characteristics of what you are trading before you put your money down. In our view, these types of funds are not meant as long-term investment candidates, and as long as that is understood, there are times when this kind of trade can be very profitable.
As we approach the new planting season, it is also important to understand that the emotions attached to changing weather patterns tend to create volatility during the spring and summer months in the grain markets. If the weather is too wet, too dry, too cold or too hot, the anticipated effect on yields can often magnify the effect in market pricing, one way or the other.
Accordingly, we like option spreads in a fund like CORN to take advantage of potential spikes in price and to control our risk of loss. Chart reading becomes an important exercise in this endeavor, because while fundamentals of supply and demand provide the structure for the grain markets, the emotions attached to weather patterns during seasonal periods when crops are developing can provide extreme parameters for price support and resistance.
Specifically, we are watching CORN for a potential price decline to the 34.00-36.00 range. If that happens, we will be very interested in evaluating option-implied volatility levels, as well as trading volume, to determine the best option vehicle for our trade. We anticipate using strikes in the August and November calendar months to take full advantage of the seasonal weather influences mentioned above.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in CORN over the next 72 hours.