Commodities Trading Strategies

It’s all in the spread

Trading in the commodities markets is often described as one of the most fascinating and absorbing of all the capital markets, and those traders who dip a toe in the water, often end up fully immersed, and ultimately never trade in any other market.

Commodities after all, represent the world’s largest supermarket for raw materials crucial to maintaining living standards and the global economies around the world. Oil underpins every economy, and is the single natural resource which dominates the news when prices rise or fall. Gold is another, which grabs the headlines, as investors rush to this ultimate safe haven when markets are volatile. Soft commodities are dominated by the weather and growing conditions, whilst base metals such as copper are driven by supply from major industrial nations such as China, as well as the effects of stockpiling. Demand for energy commodities can be seasonal whilst silver is driven both by demand from investors and industry.

Each commodity has its own unique profile but there is one aspect that many of them share, and this is the inter-market commodity spread.

The commodity markets in general spend a great deal of time focusing on a huge number of inter-market spreads that are driven by fundamental factors such as the interplay between supply and demand. This in turn is reflected in the production cycle itself, as the raw commodities are converted into refined products, in some cases where one commodity is substituted with another related commodity. Within this continuous pipeline, there are a myriad of ‘’spreads’’, which highlight the supply demand relationship, with the various energy crack spreads, the soybean crush spread, and the gold silver ratio being three of the most popular.

The crush spread

If we consider the crush spread first we can think of this as the profit made by the soybean crusher. As you may already know if you have read the ‘Softs’ page, soybeans are crushed to provide two key by products, namely soybean oil and soybean meal. For commodity traders the crush spread presents an interesting trading strategy.

The typical approach is to buy the spread or sell the spread. If we buy the spread then we are expecting higher crush margins, and as such we would buy the byproducts and sell the soybeans themselves, or alternatively if we sell the spread, then we would buy soybeans and sell the byproducts. The spread is typically achieved using ten soybean futures contracts to eleven soybean meal futures contracts and nine soybean oil contracts. However, to make things very simple one could simply buy and sell in the ratio one to one to one.

In order to arrive at the crush spread in cents per bushel, we have to do some unit conversions, since all three commodities are quoted in different formats. Soybean oil is quoted in cents per pound, soybean meal is quoted in dollars per short ton, whilst soybeans are quoted in cents per bushel. In terms of the crushing process, this generally produces around 11 pounds of oil per bushel and 44 pounds of soybean meal.

So in order to convert to cents per bushel we simply multiply the soybean meal prices by 2.2 ( converting to cents per bushel), add the soybean oil price multiplied by eleven, and then subtract the soybeans price. This gives the crush spread in cents per bushel.

The crack spread

The oil crack spread is similar to the crush spread for soybeans, and is referred to as the crack, as oil is refined or cracked into various refined products such as gasoline and heating oil. So once again we have a spread which is created between the raw product and the refined or byproducts of the refining process. In this case the spread or the profit for the refiners, is between crude oil futures and a combination of gasoline and heating oil futures. In order to construct the three legs of the trading strategy for oil , we first need to identify the approximate quantities of the cracked products produced from a barrel of crude oil. The general rule of thumb is that from three barrels of oil, the market can expect to see two barrels of gasoline and one barrel of heating oil. So using these ratios, we could then buy or sell the crack spread as follows:

For a buy, where we expect to see refining margins increasing, then we would…

  • Buy two RBOB gas futures, one heating oil futures contract and
  • Sell three oil futures.

Alternatively, to sell the spread we would…

  • Sell two gasoline futures, along with one heating oil futures contract, and
  • Buy one crude oil futures contract.

Once again we have to deal with the different units for each futures contract, and to simplify this, we could simply trade one crude oil futures contract against one heating oil futures contract, or alternatively one crude oil contract against one gasoline futures. Crude oil futures are based on the delivery of 1,000 barrels whilst heating oil and gasoline, are based on the delivery of 42,000 gallons. So to convert our crude oil and gasoline spread, we simply  multiply the gasoline futures price by 42, and then subtract the our crude oil futures price, to give the spread per barrel. The same maths is applied to the crude oil and heating oil spread which once again gives the spread per barrel.

These spreads are of course seasonal with demand for gasoline increasing sharply in the summer months in the US, as the so called ‘driving season’ takes effect pushing gas prices higher as a result. The converse of this is demand for heating oil which reaches a peak in the winter months, although heating oil is slowly being replaced by natural gas.

Gold silver spread

Finally we have the ratio between gold, the ultimate safe haven and precious metal, and silver, the alternative to gold as an asset, yet classified as an industrial metal due to its increasing demand in a variety of industrial processes.

The ratio itself is simply one price divided by the other with the price of gold divided by the price of silver and is used by investors and the market as a general indication of relative value. The simplest strategy to employ here is one using options where we purchase ‘’put options’’ on gold and ‘’call options’’ on silver when the ratio is high, and the opposite when the ratio is low where we sell ‘’put options’’ in gold and sell ‘’call options’’ in silver. The strategy is based on the assumption that the spread will fall if the ratio is high, and increase if the ratio is low. This is a longer term strategy, and as such we would look to buy or sell long dated options or leaps when trading the spread using this strategy.

Whether you are a spread trader as outlined above, or a simple trend trader in the commodities markets, one of the keys to success is in understanding and watching price activity in related markets. In the case of a spread trader, it’s watching those products and instruments which give signals of a change in the underlying spread. So in the case of oil for example, the relationship we watch here is between oil, heating oil and gasoline, whilst in the soybean crush spread, its soybeans, soybean oil and soybean meal.

Or since commodities are priced in US dollars we could watch for  strength or weakness in the US dollar, in particular those commodity currencies which tend to correlate such as the CAD/JPY, the AUD/USD and the USD/CAD.

Understanding inter market relationships is key for the commodity trader, regardless of the strategy you are using to trade, because being aware of movements in related markets significantly increases the likelihood of a trend speculation being accurate, and therefore increases the percentage of winning trades.