A common theme in investing is that, in the long-term, asset prices adhere to fundamentals. The road to adherence is often an irregular one, prices overshoot and undershoot along the way...but ultimately, they behave like obedient children.
Sometimes though, the relationships between asset prices are hidden from the eye. Peer through the layers and one might just be able to come up with a relationship that could form the basis of a trading strategy. 'Corn'y Connection, is one such linkage...
The Craze for MaizeLot of factors have driven corn (maize) prices of late. The rush of demand for ethanol has ensured that corn finally got its due. Apart from the fundamental factors of demand and supply, speculative demand for the commodity has served to increase the volatility in corn prices. Not surprisingly, corn prices have surged quite a bit (refer adjoining figure).
Along with the rise in corn prices, the 200-day historic volatility has increased significantly. Corn, and indeed other agri-commodity prices, tend to be influenced by acreage reports. A higher than expected acreage, tends to be bearish for prices and vice versa. The drop in corn prices towards end-June of this year was one such occurrence.
The Implied Volatility - an indicator that reflects among other things, the uncertainty in the human mind - tends to pick up just before the acreage reports and drops off once there is 'clarity' in the direction of prices. Another obedient adherence to fundamentals.
So far...so good. What about the trading strategy? And...did someone mention Soybean (Soy for short)?
LOSHing the two...and the 'Linkage'
LOSH stands for 'LOng' and 'SHort'. The trading strategy is simple. You go Long on one commodity and Short the other. So where does the profit come from? Here is where the unseen linkage comes into play. A chart is in place to help us.
Corn and Soybean prices have probably little in common when seen in isolation. But combining the two throws up a potentially profitable combination. Dividing the Soybean price with the Corn price yields a rather queer combination. The chart depicts the Soybean/Corn price ratio over a two-year period. The horizontal line is the historical average of the ratio (about 2.23).
There isn't anything special about 2.23. The trading strategy is based on the concept of 'reversion to mean'. If the ratio overshoots the mean for a while, it will eventually fall back to its historical average. The same holds true for undershoots as well. To be sure, there is nothing to prevent the mean itself from fluctuating over time.
The circles in the chart show possible trading opportunities to exploit any discrepancies from the 'normal' condition. Whenever the blue line crawls above the brown, the trader can Short Soy and Long Corn. Eventually as the ratio reverts back to the mean, profits get realized. Conversely, when the blue line sinks below the brown, Long Soy and Short Corn is the solution.
The circles also show the return that could have been realized by executing the strategy. One wouldn't have done too badly in my opinion...
Why does it work? One possible reason is linked to the limited cultivable area available to a farmer. As crop area is limited, a farmer would choose to cultivate one of many crops available, based on likely future prices. Sowing corn over soy in one year will lead to an excess supply of corn relative to soy the next, thereby leading to a favourable demand-supply situation in soy versus corn. As supply keeps fluctuating, so do prices, which may be posited, in general, to move in opposite directions.
What does the chart say now?
The ratios is far above the historical average, and, more importantly, it has broken the historic high as well. This could indicate two things. One, probably the Golden number is on its way up, in which case, one would want to wait to see further price development before entering into a trade, or, two, its a fantastic opportunity to play the LOSH strategy. If the reversion to mean holds true, then there is good money to be made along the way. I am betting on the latter.