While Calendar Spreads may seem confusing at first, they are actually easy to understand, and more importantly, very useful for understanding all kinds of #commodity markets from #Coffee and #Cocoa to #Gold and #Oil.
In this article, we will first cover what a calendar spread is, then dive into how they behave, and most importantly, how calendar spreads can predict prices and provide insights into a commodity market like coffee.
So what the heck is a calendar spread?
Let’s use a simple example.
There are 4 #coffee #traders: Tina, Juan, Mike and Lia. Tina is selling her coffee to be delivered in 1 month at $2.50, Juan is selling coffee in 2 months at $2.60, Mike in 3 months at $2.70, and Lia in 4 months at $2.80.
The calendar spread between each of these sellers is -10c. This is because if you buy the nearby coffee from Tina, and sell the next month from Juan it will cost you -10c (in other words you would make 10c).
This is the core of what a calendar spread is, the price differential between buying and selling a commodity at different times.
#Futures trading works just like trading with our friends Tina, Juan, Mike and Lia. All #commodity #futures #markets are structured with delivery contracts every few months. So, for #Arabica coffee, the futures contracts are March, May, July, Sep and Dec. Each of these futures contracts are traded throughout the year and the differential between these prices are called “calendar spreads” (also called a “switch”).
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The collective pricing of all the different futures contracts of a particular #commodity is called “structure” or “market structure”.
You may have noticed that the #coffee futures in our little example become more expensive the further out in time that they go. This is the normal way that we find commodity market structure and it is called “Continuation” or “Contango.” A commodity market in contango is normal and occurs because of the pull of a real cost in the market, the cost of “carry”.
Looking specifically at the coffee futures market, coffee market structure provides insight into how much it costs to warehouse green coffee. This is because commodity market structure gravitates towards this cost. Let’s see how this works.
Since we can make money by buying Coffee from Tina at $2.50 and selling it to Juan at $2.60 (woohoo 10c profit!), this would attract traders to put on this trade. However, we can’t just stick 17 metric tons of green coffee in our back yard, we would have to pay a warehouse to hold it for us. We would also have to pay insurance, and we might have to borrow the money to purchase the coffee in the first place. In a commodity market we call these “carry” costs.
If the above example were a full carry market (calendar spreads = cost of carry), then the cost of carry would be 10c. So this means that when all is said and done, even though you would make revenue on you sale to Juan, all of that revenue would be eaten up by the cost of carry (warehousing, insurance, etc).
Therefore a “full carry” market is not actually a profit opportunity, its neutral. The market is saying that demand for green coffee today, is the same as it will be tomorrow.
This is not always the case, though, there are two other scenarios that we might see.
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The first scenario is bearish, and represents weak demand, it is called a “cash and carry” commodity market.
This is when the calendar spread pays more than just the costs of carrying the commodity. So in our example from above, if Juan was paying $2.65, now we have a trading opportunity to buy coffee from Tina and sell to Juan. We would collect 15c from the calendar spread, and after paying our expenses of 10c we would still make an additional 5c. This is the “cash” in “cash and carry.” This is bearish because the incentive is for traders to hold their coffee and sell it later.
The opposite situation would be if demand is stronger nearby and we start to eat into those carry costs. If the calendar spread were only paying 5c for example, this would incentivize traders to sell their coffee nearby, because if they hold the coffee and sell it later, they will lose 5c on the carry costs.
If demand is strong enough it can even push the market structure out of contango, where the nearby months are actually more expensive than the far away months. This is called an “inverted” market or “backwardation”.
A backwardated commodities market is almost always very bullish, as it indicates demand is so strong in the present that it is dwarfing prices later on, even with cost of carry.
This is exactly what happened in #Arabica coffee this past year.
The fact that the market tends to gravitate towards the cost of carry provides a valuable benchmark for interpreting market structure and drawing conclusions about the coffee market or any commodity market. Having this benchmark means that any deviation from that benchmark will first and foremost provide a clue about global demand.
Inversions especially show that there is a strong bull market brewing, and similarly, when inversions collapse can be an indication that the bull market is over.
Another more subtle use of calendar spreads is interpreting where risk is being priced in to the futures market. Often times we will see a commodity market in full carry for the first 6-10 months, but beyond those contracts the futures market may have additional premium priced into those calendar spreads.
This extra premium does not necessarily indicate increased demand, but may actually represent the lack of clarity about what demand will be that far in the future. Traders may be unwilling to sell many months in advance, because there is uncertainty over prices that far forward.
Ultimately, we can see that calendar spreads reflect the dynamic, and time-based nature of a commodities market like coffee. Coffee trading doesn’t exist in a vacuum, it reflects the decisions of multiple players across many different time frames. As traders and participants in the coffee market, we can use our understanding of commodities trading, calendar spreads, and the dynamics of how they work to help us make better decisions when participating in the physical or futures market.
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