Mikula Forecasting Company

Mikula Forecasting Company: Strategy #28: Spread Analysis

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MarketWarrior 4.0

Written by: Patrick Mikula CTA
Copyright (c)2003-06 by Patrick Mikula All Rights Reserved. (Please to not copy or foreword this article).

Mikula Forecasting Company
P.O. Box 152672
Austin, TX 78715-2672
USA
www.MikulaForecasting.com
support@MikulaForecasting.com
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When you are analyzing a market using spreads you need to understand that a spread can tell you different things in different markets. The agricultural markets have a crop season which moves from planting to harvesting commodities such as crude oil or stocks have no such season. In this article I will discuss how a spread can help you identify a bull market in an agricultural market. The chart below shows the soybean market. In the soybean market after the soybeans are harvested they must be stored which is not free. There are costs for insurance, the interest costs on loans that can not be paid back until the grain is sold and rental cost for bins if the farmer does not have enough storage space. These holding costs are the difference between the different futures contracts. For example consider future contracts that expire two months apart in January, March, May and July. The March contract would need to be priced as the January contract price plus 2 months of holding costs. The May contract would need to be priced as the January contract price plus 4 months holding costs. The July contract would need to be priced as the January contract price plus 6 months holding costs. When the nearby contract price moves above the father out contracts it indicates that customers are willing to pay a premium to get the agricultural product right now because they believe prices will be going up in the future. When this happens it indicates that a bull market may be in-force and you should watch this market for an uptrend.

The chart below shows the July 2005 soybean contract which is the nearby contract as price bars. Also shown is the May 2006 soybean contract which is a farther out contract and is shown as a blue line. The spread line in the sub-chart shows shows the difference between the two contracts. Notice that the nearer contract moves above the farther contract in early March 2005 around the price 626. This indicates that there is strong buying in this market. Between points A and B on the chart below the nearer contract was above the farther out contract and the market moved up from the 626 level to approximately 755 during this four month time period.


The soybean market is currently displaying a normal market where the farther out contracts are higher price than the nearby contracts. The chart below shows a normal soybean market with the January 2006 contract shown as price bars and the July 2006 contract shown as a red line. This is not the opposite situation from the chart above and does not indicate a bear market.