Hornissen : COFFEE vs LUMBER Short/Long Arbitrage in Softs
Based on the current spot price $217 one Lumber futures contract is worth $24,000, one Coffee futures contract at the current price $224 is worth $84,000 at full value. The prices are converging and diverging for some time since 2010 and trade opportunity exists. Lumber is a much cheaper commodity with much better future prospects from Coffee, Lumber market is trade protected in U.S. and as price declines continue, many lumber mills close these creating a shortage that will result in a very sharp future price appreciation. Current LB prices are low even for a housing recession, low compared to historical average price. Today's LB price is almost the same as it was during bear market of 1987 when US$ was worth much more or more precise 40% more than today compared to a basket of major world currencies. For example when US$ Index was at the top in 2002 at 120, Lumber was worth same as today, since then hundred of lumber mills closed but price remains the same. During bear market for US$ lumber price reached $450. Summing it all you get a clear view of the LB situation, it's very cheap no matter to what you compare it. Whatever will happen to the housing market, US$, stock market Lumber has only one way to go - up, up and away. So why this long Lumber/short Coffee trade?
YOU ARE FAMILIAR WITH LONG/SHORT EQUITY TRADE, WHAT ABOUT COFFEE/LUMBER ARBITRAGE - Deutschemark - Seeking Alpha
I use this particular trade because LB market is in contango with all further expirations trade at the higher price from the spot. If November 2011 LB price is $217 so November 2012 trades at $280, almost 30% premium over 12 months. Coffee December 2011 and Coffee December 2012 are worth almost the same, there is only 2% premium over 12 months. That's why selling Coffee short and buying the Lumber you get no risk trade with high future return. You must sell short 1 Coffee contract/buy 3 Lumber contracts. Because each time you will trade only nearest expiration contracts, you will pay for Lumber more each time losing this way 30% a year if Coffee will stay the same, when Lumber will enter bull market then it will be worth to buy it at any price each time, because it will rise to $1000 as well and Coffee will not rise 500% over the same period. Because price trends are very sharp in Lumber your arbitrage trade will always be profitable and by buying each time spot you will get all the action. This trade is liquid enough to facilitate a hedge fund allocating to it up to $10,000,000 because LB is not a very big market in futures compared to coffee. $10M is a lot for a small hedge fund while it's nothing for a medium or big fund, I would not recommend this trade for any fund with over $200M AUM, such big funds will do better to buy spot lumber and find a storage for it, selling it only when the price will be right. If you know how to place a huge quantities of soft pine and other wood for storage for few years and keep it safe, your $100M investment can return 500% in less than 10Y, by holding very big lumber stock you will be able to sell it on the spot market or future market, also keep in mind that Lumber was not in a bubble yet, once it will reach it's price based only on supply shortage which I think is about $600, the speculators will do the rest and that's why $1000 Lumber it's not a fantasy, it's coming for real. I am ready, are you ready to rip this kind of rewards with no risk? If not you somebody else will do it.
Same price, different potential.
Coffee up 400% compared to Lumber, something is wrong, some things will not stay the same.
No change in price over 40Y, add here only inflation factor and you are in heaven.