Wheat is a notoriously difficult market to trade. With it's extremely high cost of carry, not only do you have to be directionally correct, but timing needs to be near perfect as well.
Every so often we get a technical setup which offers us great odds, and the recent selloff in Wheat has provided us with just that.
We like to see traders create extremes in sentiment and price, and then look to capitalize on the eventual reversion to the mean.
The first thing to note is that this 10 day 50cent selloff in Wheat ranks in the 15th percentile of all 10day drawdowns going back to 2008. While not a buy signal in and of itself, it shows us that it has exceeded 85% of all 10day drawdowns, and we should be stalking for a end to this drop, which is statistically due.
Next is the price action as it relates to our favorite short term trend indicator, the 3PC 4day adaptive channel. Rather than plotting price alone, we factor in a volatility and weighting component. The adaptive bands tend to support and repel price as it oscillates between highs and lows.
However, during this recent collapse, price has not only given multiple prints below the 4day low, but it is stretching well below the lower band.
We measure price extension from our adaptive channel bands to locate price extremes. We then Score this divergence between price and band on a 18month relative basis. What you find normally is that the RS Score will be at or near 100% most of the time as price rarely prints a close below the 4 day. When it does that score will drop towards 50, or in extreme cases to 30% or below.
Please look here:
Today we see Wheat has closed a whopping 13.75 cents below the 4day, giving us a RS Score of 26% which is extremely low for this indicator.
Why do we care about this? Because its a valuable tool for Overbot/Oversold status, and we can analyze price dispersion throughout history where there have been similar weak readings.
Please click here:
Here we are using the Alchymist query tables to measure all instances in Wheat where the RS Score of price extension below the 4day channel ranks at 30% or below.
We can see going back to 2009, there have been 26 such instances. Looking 20 days forward we can see a extremely bullish price distribution. In 70% of all cases, prices advanced 28.25 cents from the close. while price declined only 6 cents.
In Poker speak, this is giving us pot odds of better than 4-1 to bet long here, so we really have no choice but to do exactly that.
Our recommendation is to buy May Wheat at 484, and hedge this with a Risk Reversal, buying the May 475put, and Selling the May 525 call - This hedge should cost you approx 6cents with Max upside of 40 cents. As this is a 60Delta hedge we will use a hourly close below 470 as a stop - or 9cents planned risk for the trade. With max upside of 41 cents minus 6cts for the hedge, this is 35cents for a very respectable 4-1 R/R setup.