Savvy traders, who understand the term structures of futures markets, often use the butterfly futures spread to isolate certain contracts in which they feel demand or supply will be the strongest or weakest. Some people are only aware of the options version of this trade (read the past article). While the futures version of the butterfly spread contains four legs similar to the options version, the execution and the “why” behind getting involved will be a little different.
How the Butterfly Futures Spread works:
The Butterfly Futures Spread will combine a near term bull spread and a longer term bear spread (or vice versa if bearish). We will buy two different months, and then sell one month twice. The month we will sell twice is referred as the “whipping post” because we believe it will underperform the other two months that we buy individually. This spread is popular because it offers cheaper margins rather than outright directional trades. In my opinion, many perceive this strategy as less risky because you are long and short the same commodity, just in different months.
In a market like corn, the term structure will offer many opportunities to gain profit from the changes in prices in different months. Because of the fundamentals of the grain markets and the fact that new supply will be on the market only a few times a year, the term structure can change drastically depending on supply/demand and fund movement. In the case of our example below, we will sell the September contract twice, making it our whipping post. Note: you always want to make your sale in what you perceive to be the weakest month. How to determine which month will be the weakest will take some homework. Let’s look at a real example:
Hypothesis: Due to the fantastic weather farmers in the Corn Belt have had to plant corn, it is believed that they will be planting sooner and with fewer delays. It’s no secret that the trade is pricing in a mega crop for the December contract being grown this summer. However, the weather should shift much of the supply currently priced in the December contract up to the September contract. This price shift should happen during the early planting process from now until mid-July. Currently, the September contract is $.20 per bushel, more than the December. Every year, since 1996, this spread has been at a carry (Dec over Sep), and I believe this trend will continue.
There is a fundamental caveat we need to be aware of — the US Corn carryout (stocks on hand). Because the carryout is so tight, any weather hiccup or demand shock could send the summer old crop corn contract (July) relatively higher compared to the more deferred contracts, much like we saw last summer. Because of this, we would like to have protection during the early part of the season to protect against new crop losses or a war which would tighten supplies further. This kind of situation calls for getting long corn this summer. To do this, we will buy the July contract and sell the September contract again. If there would be a supply shortage, the July should run up against September.
The Plan: If you trade on a platform, like the DT Pro or Vantage, you can enter the spread orders on the screen. If you have a platform that will not support spread trading, you will need to “leg in” to the spread by doing each contract individually. We prefer to do all orders in the spread market if possible so if you have a PLUS or PREMIUM broker set up, without one of the aforementioned platforms, you can get these done via the spread market either on the floor or the screen.
Here are the prices as we look to enter the trade, with our purchases in green and our sales in red:
July Corn: 626-0
September Corn: 559-0
December Corn: 544-0
The way we will track the spreads will be to follow the July-Sep leg and the Sep-Dec leg separately. Even though I look at this butterfly spread as one big trade, I will still use stops and targets on each leg to make the execution smoother and easier to follow. Below, you can see the risk/reward plan for the trade. If the trade goes to plan, I expect the July to get back over a 1.00 inverse to the September and the December to get to a 15 cent carry (right now it’s is inverted) over the September for a profit of 28 cents on the July-Sep leg and a 30 cent profit on the Dec-Sep leg, making the total profit for the trade 58 cents, or $2900 dollars.
STOP ORDERS DO NOT NECESSARILY LIMIT YOUR LOSS TO THE STOP PRICE BECAUSE STOP ORDERS, IF THE PRICE IS HIT, BECOME MARKET ORDERS AND, DEPENDING ON MARKET CONDITIONS, THE ACTUAL FILL PRICE CAN BE DIFFERENT FROM THE STOP PRICE. IF A MARKET REACHED ITS DAILY PRICE FLUCTUATION LIMIT, A "LIMIT MOVE", IT MAY BE IMPOSSIBLE TO EXECUTE A STOP LOSS ORDER.
This is a long term trade, and the plan could change along the way. However, with these spreads in place, I am confident that we will have the time to recognize those changes and adjust. The biggest fundamental factors that will affect the trade will be the planting progress reports that are released Monday afternoons and the export sales reports released on Thursday mornings. Those reports combined with the monthly WASDE reports should give us enough fresh information along the way to keep the Dec prices supported and the July prices running higher.
For more questions about this type of trade, contact us at 800.800.3840.
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