Trade Your Grain Positions Better by Using Gro to Calculate Carry

27 February 2020

A calculation called “carry” helps grain handlers to decide how much grain to store, and food companies to determine the best time to make purchases. Carry, which can be calculated using the Gro Intelligence API, is basically the price difference between different futures contracts and can reveal a lot about what grain markets are expecting from upcoming production and demand.

If the concept of carry is foreign to you, read on to get the basics and learn how it is an integral part of risk management and trading.

The purpose of carry is to reward those storing, or carrying, grain from periods of abundance into periods of scarcity. This was one of the central reasons for the creation of commodities futures markets, and it is today used both as a tool of risk-averse grain handlers and a common instrument of speculators.

The terminology of carry may be confusing, but its mechanics are simple. Grain handling companies lower the risk of holding grain by hedging those physical purchases with sales of futures. They hold both the physical and financial position until the eventual sale of the physical bushels, at which time they also unwind their futures position. The difference in the price of the two is technically called a “calendar spread.” Calendar spreads in which the price of the later contract is greater than that of the earlier contract is called a carry, while the opposite is called an inverse.

Historical average spreads of front-month wheat futures contracts relative to their nearest contract have varied widely in recent years. Negative values on this chart indicate a ‘carry,’ meaning a later-dated contract is higher priced; positive values on the chart indicate the opposite, in what is called an ‘inverse.’ The July 2012 contract, for example, had a powerful carry of 50 cents per bushel, a result of large wheat stocks in previous years. By contrast, strong inverses during the harvests of 2015 and 2016 were the result of temporary spikes in demand relative to supply. The average carry for the current front-month contract is shown as a red dot. Calculating the level of carry or inverse can help grain handlers and food processors manage risk in their grain purchases.

The real-world cost of storing grain—such as the costs of payroll, interest payments to the bank, and mortgage payments on the land—tends to be at least partially offset by the carry the storer accrues. A futures contract exists for multiple calendar months, and as each comes and goes, grain storers trade in their expiring contracts for newer contracts. Well-supplied markets pay grain storers handsomely in this transaction, while the holders of the long futures position suffer. When a negative supply shock such as a drought, or a positive demand shock such as a boom in exports, cause frenzied purchases of physical commodities, the carry can become an inverse.

In current markets, near-term contracts for US soft red winter wheat are arranged in a small inverse, with the March contract trading for 5 cents more per bushel than the May contract. Seasonal tendencies often result in inverses during this time of year. But the current inverse also is being driven by expectations that US wheat exports will be stronger this year, which could draw down stocks. (The March 2020 contract over its full life has averaged a carry of 3 cents against the May 2020 contract, as shown in the chart higher in this Insight article.)

The March 2020 contract for US soft red winter wheat is currently trading for 5 cents more per bushel than the May contract, amounting to an inverse. Helping to drive this are tighter market conditions because of declining wheat stocks (bold green line) and rising exports (bold blue line). The previous year’s stocks and exports are shown by other lines. Click on the image to interact with the charts on the Gro web app.

Food companies use carry to manage risk in their grain purchases. For example, a wheat mill might currently buy July futures at $5.35 a bushel in anticipation of its summer physical purchases. If poor weather were to lead to a domestic crop problem, the July futures price would likely rise, say by 65 cents to $6.00 a bushel. Meanwhile, September wheat futures, currently at $5.40 a bushel, might rise by 35 cents to $5.75 a bushel. The mill has experienced no loss but notices the spread has changed by 30 cents a bushel.

At this point, the mill would have multiple options. It could continue as planned to purchase physical grain in July, experiencing no financial loss on its hedged bushels. But if the mill had the operational flexibility to delay its purchases, it could capitalize on the newly inverted market by selling back its July contracts and purchasing September contracts. In this maneuver, it is selling an expensive contract and buying a cheaper one, allowing it to pocket the 25-cent-per-bushel difference. As a wheat mill may be purchasing a 370,000-bushel train full of wheat, it would secure roughly $92,000 in extra profit.

Even without trading on the basis of carry, a market participant benefits from understanding the signals it is sending. A strong carry may signal that the market is replete and supplies should be saved for later. A mild inverse may signal the market is in more urgent need of grain and is willing to pay a premium for quicker purchases. At its extreme, an inverse can signal frenzied purchases and an inability to wait for future supplies.

By using carry both to understand market sentiment and to take action to protect profits, market participants can become increasingly sophisticated traders and risk managers. In a related Insight, we show how Gro data can be used to identify connections between carry and balance-sheet quantities, as well as how to turn those connections into actionable conclusions.

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