Trading Educators Blog
Can seasonal transitions help a commodity trader?
Yes! Seasonal transitions create workable Spread strategies. I'll let my Andy Jordan, an expert in seasonal fundamentals, answer. Andy! You have the floor:
"Change gives birth to risk – but also creates opportunity. Seasonal transitions create workable spread strategies because markets have to struggle to maintain equilibrium between supply and demand as conditions undergo dynamic change through time.
"The transition from one crop year to the next in any market can sometimes be difficult; but the coexistence of prospects for huge new supply, damage to the crop, and heavy consumption can create extreme tension. Final old-crop inventories can be neither too much nor too little. If old-crop inventories are too great, they can burden new-crop prices throughout the following year. If old-crop inventories are too small, they can aggravate any crop problem amidst the season of heavy consumption. Until harvested, the new crop faces the potential for weather, disease, insect, or damage from a variety of natural or man-made disasters. Therefore, the contract representing new-crop production must balance prospects for both new supply and any sort of disaster.
"Prices tend to decline as supply peaks. But the market has often changed thereafter. When prices are low, stocks begin to decline. By about a month before harvest, the market may begin to build in a premium to offset the risk of something going wrong.
"But does the market prefer old-crop security – or new-crop prospects? Though not often dramatically so, it has tended to adhere to the philosophy of 'a bird in the hand is worth two in the bush.'
"Next, let's look at a seasonal spread trade that has nothing to do with crops or harvest. A good example would be crude oil. Demand rests primarily in two areas of seasonal product consumption – gasoline in summer, and heating oil in winter. In both cases, inventory accumulation precedes peak consumption. In spring, for example, steadily improving driving conditions increases daily consumption even as the industry accumulates supplies for the opening of the summer vacationing and driving season. This combination accelerates demand for gasoline – and therefore for crude oil to refine. Accelerating demand tends to drive prices – and bull spreads.
"Its corresponding dynamic tends to begin in August, during which refiners often shut down temporarily to perform maintenance and to retool facilities. When they return, the industry begins the process of accumulating inventories of heating oil. As refineries gear up to produce at capacity, demand for crude oil accelerates into October – often driving bull spreads."