Liberty Maven

[Editor's Note: Liberty Maven welcomes Matt Malkus to The Free Investor contributor team. We look forward to learning more about investing in general and "liberty style" investing in particular from Matt.]

Note: This will be part one in a continuing series of articles related to commodity spreads, offering advantages and disadvantages, potential mistakes, and detailed examples.

The world of commodities is a fast-paced, highly-leveraged world where gains and losses per day can be in the thousands, even in the smallest of trades. This offers unique advantages and disadvantages over equities, where one share is just one share, and its face value is what you pay. For example, the “face value” price of a soybean contract is currently at $1357.75 (and this is what you will pay to obtain it), this is the price of 100 bushels of soybeans. However, one contract controls 5,000 bushels of soybeans, making a change of $1 in the contract price a change of $50 in actual value in your position. A “limit” movement (maximum allowed) of $50 in the contract price means gaining or losing up to $2,500 in a single trading day on a single contract!

As such, if you can’t afford to lose a few thousand dollars on a trade, it is not advisable to purchase a contract outright without employing a strategy that greatly minimizes this risk (while, of course, also limiting the upside potential). One of the major upsides to dealing with commodities over equities in developing a strategy is the relationships present between multiple markets. In equities, for example, shares of technology companies may all move loosely together – but if Apple comes out with an earnings report, announces a new product, or hires a new CEO, it may not follow the broader sector.

In commodities, these factors are usually absent. Take, for example, the soybean market. A market on a physical commodity is much more dependent on simple supply and demand factors. Weather is a major factor in any agricultural market, as good weather means higher supply and lower prices, or vice-versa. The weather factors connect most agricultural commodities grown in the same areas – soybeans, corn, and wheat, for instance. However, even stronger relationships exist when we look at derivatives of the same crop: soybean meal and soybean oil are also traded commodities. This can be applied outside of agriculture, of course: precious metals (gold/silver), energy commodities (crude oil/natural gas/ethanol), and many other sectors also have commodities whose supply/demand structure are greatly influenced by others.

As an example, let’s take a look at the relationship between soybeans, soybean meal, and soybean oil since the beginning of the year. To do this, we will use the ratio of the prices of their contracts, by dividing the higher priced contract by the lower, and observing the value.

Soybeans August 2008 (SQ8): $1357.75

Soybean Meal August 2008 (SMQ8): $373.90

Ratio: SQ8 / SMQ8 = 3.631

By charting the changes in this ratio, we can see how strong the relationship is (by observing how stable or volatile the ratio is), and gather insight on when to act. First, though, we must know how to act. Since we are dealing with a relationship between two commodities, we will want to take advantage if this ratio is higher or lower than normal by creating offsetting positions. If a ratio of 3.631 is lower than normal, this means that soybeans are undervalued in relation to soybean meal – in this case, we would buy the undervalued commodity (soybeans) and sell the overvalued (soybean meal). If this ratio were high, we would do the same thing, buying soybean meal and selling soybeans.

Here’s a chart of the relationship between the soybean / soybean meal ratio (also called the “crush spread”):

As you can see, the ratio is quite low in relation to the trend since the beginning of the year. In this case, we might think about buying the undervalued commodity (soybeans) and selling the overvalued (soybean meal). Before you do, however, there are many potential dangers and mistakes which can easily be made by investors who are new to the world of commodities. In the next installment, I’ll point out some of these dangers and mistakes, and show you how to capitalize on a relationship like the one above, while minimizing the risk associated with taking the position.

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Matt Malkus is a statistics major at Virginia Tech entering his senior year, with more than 5 years of experience in equities markets, and has recently entered into the world of futures markets. He currently serves as the Chief Information Officer of the school’s Society of Individual Investors.

Positions in this article are the opinions of the author and guarantee no future gains. As always, investors are advised to take on only the amount of risk that their portfolio can comfortably handle.