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Spread Scan Issue: February 21, 2007 - Volume 132

Today we consider an intra-market soybean meal spread: long July 07 Soybean meal and short September 07 Soybean meal (SMN7 – SMU7). This spread trade is mainly based on the optimized seasonal entry (02/26) and exit (05/11) dates and on its reliability over the last 15 years. Just following the statistical entries and exits, the spread would have made money in all of the last 15 years, with a maximum draw down of only $270 in 2004.

Traders may want to enter the spread at a value of –3.5 limit. Margin for the spread is $169 (reduced margin). Suggested risk is $300. Initial projected objective is $300, then a move to 5.0 or higher. Basis is seasonal (app. 2/26 – 5/11).

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Something important from Joe Ross about bull and bear spreads:

Bull and bear spreads perform opposite economic functions. The former rations demand; the latter distributes supply. In most demand-driven markets for a physical commodity, nearby contracts increase relative to deferred contracts. In the first stage, usually associated with plentiful supply and futures in their normal progression (Contango — prices being progressively higher in the deferred months), cash prices stabilize while commercials continue to buy what they need as they need it, as opposed to forward pricing. This buying on an as-needed basis steadies the nearby futures while further eroding deferred prices. As demand begins to outstrip production, cash prices rise. Knowledgeable commercials not only continue to buy their immediate needs, but also begin to slowly accumulate physical inventories. Their actions affect futures in the same way as does tossing a pebble into a pond, which creates concentric circles - most intense nearby, and progressively less with distance. In the latter stages, if demand exceeds supply, the price for nearby delivery can exceed that for deferred delivery as the market wants the physical commodity now, not later. If that keeps up, futures can go into backwardation (inverted market) - a price structure in which progressively deferred contracts are priced at progressively greater discounts. The eventual economic function of continued bull spreading is to restrict supply to the most productive (efficient) demand by making immediate consumption the most expensive.

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