Last time, we touched on the basics of commodity spreads and went over the basic example of soybeans (S) and soybean meal (SM), or the “crush spread.” We noted that by tracking their ratio (S/SM), we could identify times when the relationship between these two contracts is out of alignment with the historical relationship, and take advantage by buying the undervalued contract and simultaneously selling the overvalued.
An important question is: how much do we buy and sell? The obvious (and easiest) answer is to buy one contract of the undervalued commodity, and sell one contract of the overvalued. However, each commodity gives the owner power over a certain number of the commodity – one soybean contract controls 5,000 bushels, for example – and the values of these contracts might be different.
To give an example, let’s look at the soybean / soybean meal spread that we were looking at before. As the chart showed, the ratio of 3.631 looks lower than usual, meaning that soybeans are undervalued and soy meal is overvalued. A $1 move in the contract price of soybeans is a move of $50 in actual value; a $1 move in the contract price of soybean meal is a move of $100 in actual value. These can be calculated from the screen captures above – on the left is the “tick” size for soybeans, and on the right is the “tick” size for soy meal. As the ratio suggests, the two typically trade at a ratio of (roughly) 4 to 1 – that is, the price of the soybean contract will move 4 times as much as that of the soy meal contract. Let’s assume that tomorrow, the soybean contract moves up $4, and the soy meal contract moves up $1, in accordance with this ratio.