The soybean versus corn spread has received a great deal of justifiable attention this year and the current spread between the two markets is still near its all time highs. The last statement however, generates as many questions as it answers. We’re going to look at some of the difficulties in quantifying this spread trade, place it in its historical context and walk through the math so that the next time someone mentions this, you can determine if they’re comparing current crop soybeans versus corn or, if they might as well be talking about apples and oranges.
Every trade that is made is based on comparing current prices to past prices in order to determine future prices. Day traders may use something as small as a tick chart for scalpers while Warren Buffet probably uses monthly charts to plan generational trades. The problem with commodity futures data is that the contracts expire and depending on the market, there can be a huge gap in prices in the roll over from the expiring contract to the new front month contract. Obviously, corn and beans both fit this description.
For example, September beans are the last of the old crop beans to be traded. Old crop beans are the available supply currently in storage. When this contract expires many traders will begin trading the November contract, which is this year’s bean crop in the ground. The dynamic between these two contracts can be substantially different. Compare this to a currency contract that expires quarterly. There’s no difference between a September Yen and a December Yen. A Yen doesn’t spoil, isn’t affected by drought and won’t catch a disease. Thus the $.50 cent per bushel gap between the September and November bean contracts represents far more factors than the .0008-point spread between the September and December Yen contract which is primarily attributable to the discounted interest rate differential.
Before the historical boundaries of an agricultural market can be determined, the right data must be chosen. There are three types of historical data used by trading packages and data retailers and each has their place. Back adjusted and ratio adjusted contracts use mathematical equations to fill in the roll gaps between contracts. In order to compare current crop soybean and corn spread differentials, only non-adjusted original contracts can be used. This is by far the most cumbersome process but it is the only way to answer the actual question being asked; “How has the current crop corn and bean spread behaved between July 4th and November 4th?” These dates were chosen to be past the spring planting fears while still being relevant to our current situation while the November 4th ending date eliminates any first notice day or delivery issues with the November soybean futures contract.
Once the proper tool (data) has been chosen for the job the proper measurement methodology must be determined. Google returns nearly 2,500,000 results for, “bean to corn ratio.” Clearly, much has been written on this topic. I have a couple of issues with this process. First of all, gong through 30 years’ worth of data yields the following bean to corn ratio results between the first week of July and the first week of November. The average movement in the ratio is .001. Meanwhile, the actual average movement of the underlying contracts is about $.27. Therefore even a negligible change in the ratio reflects an average of $1,350 difference per contract in your trading account. Ratios don’t pay bills, cash differentials do.
Secondly, and perhaps more alarmingly, the negligible difference in the ratio is actually an increase from 2.591 on average in the first week of July to 2.592 on average in the first week of November whereas the average $.27 differential in the outright contracts represents a quantifiable decline in the actual spread prices. Finally, over the last thirty years there have been five times when the ratio has declined while the premium in the spread increased. The bean to corn spread ratio may be useful as a general guideline but has been useless in managing a trading account.
This brings us to the current situation in the soybean versus corn spread. Using non-adjusted contracts and comparing the current setup to both historical averages and extremes, it’s clear that we are sitting at very lofty levels. Both the cash differential at $8.90 and the ratio at 3.17 are at their highest July 4th levels of all time while their historical averages are $4.42 and 2.591 respectively. Meanwhile, in May, we set an all-time high for the outright differential at $10.57 which also shows another bean corn ratio issue as its highest point was 3.62 set in June of 2008. Clearly the cash differential is pricing in the record corn crop at beans’ expense. The average decline in differential for the thirteen years out of the last thirty years in which the spread fell is about $1.20.
The last issues to address in the bean corn spread are contract size, volatility and cash management. The contract sizes of beans and corn at the Chicago Board of Trade are the same – 5,000 bushels. However, due to the much higher price of soybeans, the contract values are clearly different, currently around $54,500 for soybeans versus $18,500 for corn. Capturing the differential movement requires placing the same amount of capital on each side of the trade, not the same number of bushels. The current levels justify 3 contracts of December corn versus 1 contract of November soybeans. This will provide equal leverage on both sides of the long and short ledger. Finally, we come to margins. The CME Group only recognizes this spread on a 1 to 1 basis, which has an initial margin of $2,806. The additional two corn contracts require another $3,300 in initial margin. Thus, the exchanges will require $6,106 in margin to buy 15,000 bushels of corn worth approximately $55,500 and sell 5,000 bushels of soybeans worth about $54,500. And that is how the soybean versus corn spread should be traded.
If you’re interested in our other spread trades, you’ll find them here.
