Spotting arbitrage opportunities is something traders in the global agricultural commodity markets are very familiar with.
In this interview, Doug Christie, an ex-Cargill agribusiness executive and author of the newsletter Agricultural Commodities Focus, walks us through the concept of arbitrage, as well as how traders both spot opportunities and choose which to take.
Can you explain the concept of arbitrage in the context of futures trading?
Christie: The idea of arbitrage in a commodity market really refers not to the absolute value of a commodity, but the relative value of a commodity. Either one commodity versus another, or the value of a commodity at one point in time versus another point in time, or the value of a commodity in one place in time or another place in time.
First, let’s look at one commodity relative to another. And a good example of an arbitrage opportunity that traders might look at there is the value of corn versus the value of soybeans. In the US, or in Brazil, or Argentina, or any of the big major production bases for those commodities, farmers have a choice about whether they plant an acre of land to corn or to soybeans.
That decision that a farmer makes is based on their perception of the relative value they can get from raising soybeans versus raising corn. And as we come into a planting period and, looking at farmers making that decision, one of the big impacts is the relative value of corn versus the relative value of soybeans. And in that case, markets may look at the overall supply and demand for those two products, and whether the relative prices today are set up to give farmers the right incentive to plant corn versus soybeans.
Let's take an example where the supply and demand for soybeans is relatively tight, and the supply and demand for corn is relatively loose. In that example, the market may expect that the relative value of soybeans should be high versus the relative value of corn, so that farmers have an incentive in the upcoming planting season to put more soybeans in the ground and less corn in the ground to increase the supply of soybeans and decrease the supply of corn.
Traders will look at those relative prices, the relative supply and demand, and try to assess whether that ratio between corn and soybeans is right to drive the incentives that they think are required to incentivize supply and demand of the two products. And that would be a really classic arbitrage opportunity in the ag space - corn versus soybeans as we go into a northern hemisphere planting season.
That arbitrage could play out as you go forward in time because the window for planting corn versus soybeans overlaps quite a bit, but the window to plant soybeans maybe is a little bit longer than the window to plant corn. Let's say ,as an example, we have a very cold and wet spring, and so planting gets delayed and gets further delayed. While people may have wanted to plant more corn versus soybeans, if they can't plant more corn, we end up kind of by default planting soybeans.
And in the example we talked about, the price for soybeans may not need to go as high because even though the price relationship is not as attractive, the physical alternative becomes more attractive because we didn't have time to get corn in the ground and we can still plant soybeans. That arbitrage will play out over the time of the planting season and even through the growing season. So, the relative value of one crop to another is a big and classic arbitrage opportunity in the Ag commodity space.
Another arbitrage trading strategy, or what I would call a relative value trading strategy, can be the value of a crop in one time period versus another. A classic example of that would be, "What's the value of the crop that we currently have in storage versus the value of the crop that we anticipate growing in the next year?”
That can play out as a relative gain for the old crop versus the new crop, or a relative loss for the old crop versus the new crop, depending on the perception of supply. An example of that might be that if we're in the tail end of a crop year, coming into the late summer, getting ready to harvest a new crop in the fall. If supplies are tight, the value of the crop that's remaining behind before the new harvest comes in can really appreciate relative to the value of the next crop when we know we're going to have a big supply coming in.
Traders might participate in that or anticipate that by buying the remaining old crop and selling the new crop that's about to come in - trying to participate in the gain of the old relative to the new.
In the same way, you could see that relationship go in the opposite direction. If we have plenty of supply left in the old crop and a new crop supply that's coming in, the value of the crop that's still in the bin can decline knowing that we've got a big chunk of new crop coming in behind it. So, time spreads or intercrop spreads are another example where markets can try to anticipate relative value one time period versus another.
How do traders identify these potential arbitrage opportunities?
Christie: If we look a little bit more closely at this relative value opportunity, corn versus soybeans, one way a trader might look at trying to participate in that is to look at the historical prices of corn versus soybeans and what the relative value of those two crops has been. While understanding that soybeans are typically higher priced than corn, but corn produces more bushels per acre than soy.
A trader would need to look at not just the absolute price, but the relative price. How much revenue per acre will you get from producing corn versus how much revenue per acre will be received producing soybeans? Traders might look at that price data and form an opinion or look at the ratio of those two prices. Then you might look at something like USDA reports, where each year the USDA issues a report on what it believes farmers will plant for two relative crops.
The USDA’s annual Prospective Plantings report gets issued in the spring, and it's based on surveying farmers, asking them, "What crops do you intend to plant on your land?"
Traders can use those two bits of information - historical price data and historical acreage numbers for both soy and corn - and look at the current relative prices, and look at the current forecast for prospective plantings, and then make a decision about whether the relative price is doing the job to incentivize more plantings of one crop versus another.
And if a trader perceives that the price ratio is not driving the right actions, or the reaction in the Prospective Plantings report hasn't matched up with expectations for what acreage is needed, you could take an action in the market to buy one crop, and sell the other crop, believing that that price ratio will ultimately reflect what's required to be planted.
That's maybe a more granular example of how traders will look at prices and information to formulate a strategy and then put on an arbitrage or a relative value trade.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
