It’s trading wheaty (pretty) high now...
Continuing the topic of spreads between related commodities, the Hard Red Winter Wheat – Soft Red Winter Wheat spread is another one trading at an extreme level now.
A brief explanation on the different types of wheat we are referring to here:
1) The Hard Red Winter Wheat (HRW) is the most widely grown class of wheat. A high protein product, used for breads, some types of Asian noodles and general-purpose flour.
2) The Soft Red Winter Wheat (SRW) is the third largest class of wheat variety grown in the US, lower protein wheat used in producing confectionary products such as cookies, crackers, and other bread products.
Generally, the HRW Wheat Futures (KE) trades at a premium to the SRW Wheat Futures (ZW) due to the higher protein content, however other factors such as production levels and supply demand dynamics may disrupt this spread, as seen from the wide range it has been trading since 1977.
Currently, this spread is trading close to 132 cents, with only one instance where it has traded higher, which was in March 2011 when this spread reached an all-time high of 164.
We attribute the spread trading at a high now due to the following 2 reasons:
1) The 2022 HRW production is currently the lowest on record since 1963, due to widespread droughts across many of the HRW production regions.
2) The average protein content of the 2022 yield is higher than last year, as well as the average of the past 5 years, resulting in a higher quality crop.
As a result, HRW is trading at a premium as supply shortage and a higher quality product pushes the price higher, while SRW sees average production and quality.
While it is challenging to assess the production levels and quality for the next season, from a risk reward perspective, we see an opportunity here. The past few spread peaks have been clearly marked out by Relative Strength Index (RSI) pointing oversold. With the 10-year average for the spread at 6.3 cents and the RSI now oversold, we lean bearish on the spread.
Referencing the average of the past 3 declines at 150 cents and lasting 511 days, we could set out trade levels.
If the historical pattern holds this time, a conservative target of 120 cents and a trade length of 500 days points us to the 15-cent level. We see the current set-up as an opportunistic one, with similar episodes in the past pointing lower. CME also has the synthetic KC HRW Wheat-Wheat Intercommodity Spread, which can be used to express the same view and is financially settled.
The charts above were generated using CME’s Real-Time data available on TradingView. Inspirante Trading Solutions is subscribed to both TradingView Premium and CME Real-time Market Data which allows us to identify trading set-ups in real-time and express our market opinions. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs tradingview.com/gopro/
Disclaimer:
The contents in this Idea are intended for information purpose only and do not constitute investment recommendation or advice. Nor are they used to promote any specific products or services. They serve as an integral part of a case study to demonstrate fundamental concepts in risk management under given market scenarios.
Sources:
uswheat.org/wp-content/uploads/2022-USW-Crop-Quality-Report-English.pdf
cmegroup.com/education/articles-and-reports/kc-vs-chicago-wheat-spread-a-tale-of-two-markets.html
cmegroup.com/trading/agricultural/files/fact-card-wheat.pdf
usda.gov/oce/commodity/wasde/wasde1122.pdf
A brief explanation on the different types of wheat we are referring to here:
1) The Hard Red Winter Wheat (HRW) is the most widely grown class of wheat. A high protein product, used for breads, some types of Asian noodles and general-purpose flour.
2) The Soft Red Winter Wheat (SRW) is the third largest class of wheat variety grown in the US, lower protein wheat used in producing confectionary products such as cookies, crackers, and other bread products.
Generally, the HRW Wheat Futures (KE) trades at a premium to the SRW Wheat Futures (ZW) due to the higher protein content, however other factors such as production levels and supply demand dynamics may disrupt this spread, as seen from the wide range it has been trading since 1977.
Currently, this spread is trading close to 132 cents, with only one instance where it has traded higher, which was in March 2011 when this spread reached an all-time high of 164.
We attribute the spread trading at a high now due to the following 2 reasons:
1) The 2022 HRW production is currently the lowest on record since 1963, due to widespread droughts across many of the HRW production regions.
2) The average protein content of the 2022 yield is higher than last year, as well as the average of the past 5 years, resulting in a higher quality crop.
As a result, HRW is trading at a premium as supply shortage and a higher quality product pushes the price higher, while SRW sees average production and quality.
While it is challenging to assess the production levels and quality for the next season, from a risk reward perspective, we see an opportunity here. The past few spread peaks have been clearly marked out by Relative Strength Index (RSI) pointing oversold. With the 10-year average for the spread at 6.3 cents and the RSI now oversold, we lean bearish on the spread.
Referencing the average of the past 3 declines at 150 cents and lasting 511 days, we could set out trade levels.
If the historical pattern holds this time, a conservative target of 120 cents and a trade length of 500 days points us to the 15-cent level. We see the current set-up as an opportunistic one, with similar episodes in the past pointing lower. CME also has the synthetic KC HRW Wheat-Wheat Intercommodity Spread, which can be used to express the same view and is financially settled.
The charts above were generated using CME’s Real-Time data available on TradingView. Inspirante Trading Solutions is subscribed to both TradingView Premium and CME Real-time Market Data which allows us to identify trading set-ups in real-time and express our market opinions. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs tradingview.com/gopro/
Disclaimer:
The contents in this Idea are intended for information purpose only and do not constitute investment recommendation or advice. Nor are they used to promote any specific products or services. They serve as an integral part of a case study to demonstrate fundamental concepts in risk management under given market scenarios.
Sources:
uswheat.org/wp-content/uploads/2022-USW-Crop-Quality-Report-English.pdf
cmegroup.com/education/articles-and-reports/kc-vs-chicago-wheat-spread-a-tale-of-two-markets.html
cmegroup.com/trading/agricultural/files/fact-card-wheat.pdf
usda.gov/oce/commodity/wasde/wasde1122.pdf
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