Sunday, December 4, 2011

Wheat - Corn Spread Trade Idea

As I did my research over the weekend, I was able to look through a variety of different commodity futures groups such as agriculture and energy to get a better handle on relative performance, historical relationships, etc. A potential trade that popped out to me was a spread trade, ZW-ZC. I have been quite bearish on the entire grains complex for the past month or so, in particular wheat. Although it has continued to grind lower, it hasn't broken as I had anticipated, but I noticed a clear weakness in Corn relatively over the past few sessions that was notable.

The chart above shows an 18-month performance comparison between Corn, Wheat, and Soybeans. Also included are ratio charts comparing the relative performance of each against the other. As is obvious, Corn has clearly been the outperformer of the group with Wheat bringing up the rear. However, the Corn:Wheat ratio chart shows a potential a potential topping type rectangle pattern. I would also note that the Wheat:Soybean ratio looks to be bottoming and the Corn:Soybean ratio is looking at an uptrend line test.

Looking specifically at the daily Corn chart, we see a clear year-long head and shoulder - type topping pattern. Corn seemed to have bear flagged near its neckline and has begun to break down. RSI is pointing downward, Stochastics look to be embedding to the downside, and the MACD failed to make a bullish crossover. Any technical analyst would most likely look at this chart and know where a confirmed break would occur.

The daily wheat chart is similar but a bit different. Wheat also has had a similar year-long head and shoulders type pattern. However, it has a downward sloping neckline, characterized by lower lows. As you can see over the past 2 months, attempts have been made at a breakdown that have failed. All the while, positive divergences have begun to form on the RSI and MACD. We look to have culminated in a fakeout at the end of November and broke a descending trendline on Friday.

The final chart is a spread chart of the H2 contracts (Mar '12). This chart indicates 1 contract long wheat for 1 contract short corn. Basically the difference in value between the two products. If this number is negative, corn is nominally more expensive than wheat, and vice-versa. Looking over the past decade or so, Wheat has had about $1.00-$1.50 premium to corn, although it has varied wildy at the extremes.

As you can see from the spread chart, a potential bottom looks to be forming. There is a significant positive MACD/RSI divergence and from an ichimoku perspective, price has cleared the kumo. I see the potential for an head and shoulders type bottom here and important trendlines have been marked. Ideally, I would like to see a move up to the trendlines and a pullback to the 15-18 area to hopefully be able to enter a position. I think an eventual move to the $1.85 resistance area is possible which would be a 400-700 tick gain/contract depending on entry.

WORD OF WARNING: As you can see from the spread chart, the intraday movement in this spread can get quite volatile. Over the past 6 months, there has been as high as 95 point intraday swing in this pair. As always, risk management is crucial. A difficult thing about executing this trade on IB, which is where I would be, is the lack of ability to place hard stops. If one isn't comfortable with this type movement I believe there are still two strong setups that I've posted above for each individual name. Good luck!