Coffee Calendar Spreads are On Fire

Yesterday, #Arabica #certifiedstocks dropped an impressive 70k and the #calendarspreads are going bananas. Calendar spreads in Arabica #coffeemarket are notoriously boring (unlike #Robusta), and yet this year spreads have been ANYTHING BUT BORING. #Spec interest in the spreads has driven a lot of the #bullish #price action there but this has been instigated by some very real #fundamental concerns.

In this article, we will look at what the calendar spreads are, why they reflect the #fundamentals so well, what the relationship to the #certifiedinventory is, and why they are rallying so hard.

The short answer to why spreads are rallying is that calendar spreads are known for being a fundamental #trade, and the fundamentals are strong. However, there is a lot more to the story here. Let’s begin by examining what the calendar spreads are, and that should help to explain why they reflect fundamentals.

What are Calendar Spreads?

To understand Calendar spreads, we have to understand #futures.

#Commoditymarkets are traded with futures contracts that correspond to different periods in time because these contracts are used to hedge the actual #commodity.

For “commercials” (#roasters, #traders and #producers who are engaged in actual #trading and delivery of physical commodities), time is essential.

Why? An agricultural crop that is harvested along specific crop cycles has a disconnect between when the #consumer wants to buy and when the #producer wants to sell.

Traders can buy and sell commodities “forward” (forward in time, in the future) but in order to enable this flow of goods (without taking price risk) traders #hedge these #forward trades with corresponding futures months.

These futures months have a natural “curve” to them that increases with time to account for the price of holding coffee and carrying it forward. This naturally occurring progression of increasing futures prices is called “#contango” or “#continuation” and is generally considered a little #bearish.

Think of it like this:

If a roaster asks a trader to sell them coffee right now, the trader would quote them the spot (present moment) price.

If the roaster asks the trader to sell them the coffee in 6 months, the trader would charge them the spot price, plus 6 months of “carry” costs (warehousing, financing, insurance, etc).

This difference in prices between the futures contracts generally reflects those carry costs.

However, if there is increased demand for one particular period in time, then that futures contract will rise in value relative to the others. Since this is contrary to the normal structure of calendar spreads, this is referred to as “backwardation” or “inversion.”

Trade houses keep close watch on the difference between the futures months because it has a financial impact on their business of trading hedged coffee. This difference between any two futures months is called a “calendar spread” or “switch”.

A calendar spread can be traded indirectly on the exchange by buying one futures contract and selling another futures contract from another month (called “legging” into a position), or they can also be traded directly on the exchange as its own derivative. Either way, the net effect in the trader’s futures account is to acquire two opposing (long and short) futures in different months.

Calendar spreads are an essential part of futures trading because futures contracts expire. If an individual trader wants to maintain their position past expiration, they must “roll” their contract forward.

As an example, if a trader has a short hedge approaching expiry in March, they can roll their hedge forward into a May position by “buying the switch” or “buying the calendar spread” (buying the H future and selling the K future). This has the effect of transferring their short hedge to the next calendar month, but the cost of doing it is the price of the calendar spread.

Why do Calendar Spreads reflect the fundamentals better than outright futures?

You may have heard that calendar spreads reflect the fundamentals better than the futures themselves. This is repeated for a fairly simple reason: when we offset two futures months against each other, we are removing a lot of the market noise and isolating supply and demand factors.

Let's consider the "noise" for a second. Many different factors influence futures prices.

Those of us in the coffee world are constantly watching currencies, for example, especially the Brazilian Real. We also need to be mindful of inflation, and macroeconomic commodity trends that lift the prices of all commodities regardless of fundamentals.

Technical analysis and momentum indicators also can be drivers of price in the futures markets for many commodities. However, these tend to give the same signals across the futures curve since the futures months largely move in tandem.

However, since macro and technical factors tend to affect all futures months concurrently, spread trading (buy one futures month and sell another futures month against it) eliminates this extraneous price movement. What we are left with, is the individual S&D factors for this particular time periods.

Because we are eliminating a lot of the noise, calendar spreads tend to be much less volatile than individual futures months. This makes calendar spreads an ideal trading vehicle for specs, hedge funds and prop desks that focus on fundamental analysis because they can increase their leverage while keeping low volatility.

How does the Certified Inventory affect Calendar spreads?

The key reason that the futures price reflect the price of actual physical coffee beans is because of certified inventory. Certified inventory is an arbitrage vehicle that allows physical traders to bring down the futures price if it is overvalued vs physical coffee or bring the futures price up if it is undervalued vs physical coffee.