- 4 Apr 2019
- By Dominic Sutton-Vermeulen
Introduction:
The rollover, or “the roll”, is a critical juncture in which a trader decides to move their position from the soon-to-expire front month contract to a deferred contract by simultaneously offsetting their nearby position and establishing a like position in a contract further in the future. In grain and oilseed futures markets, this is often accomplished through calendar spreads. In addition to offering traders a cost- effective and efficient way to move their position from one month to the next, calendar spreads also act as price signals to guide the intertemporal allocation of periodically produced storable commodities such as corn and soybeans. The cost of storage or “carry” links contracts across maturities and creates arbitrage opportunities for traders and hedgers alike. Grain and oilseed businesses rely on these signals when making decisions to store or consume/liquidate inventories as they reflect the current domestic and global supply and demand fundamentals relative to prevailing future expectations.
A key component of the roll, and for that matter any market, is liquidity. The more bids to buy and offers to sell at various prices in a market, the more “liquid” it is. At its core, liquidity is the collective expression of traders’ opinions on a market at any given time. The more opinions expressed, the greater the liquidity, making it easier to buy or sell at a reasonable price, lowering the cost of trade, and reducing the exposure to potential risk of holding unwanted positions. In agricultural commodity futures markets, there are several common measures of liquidity, including:
- Volume – the number of contracts traded during a given time period.
- Depth of Market – the average number of bid and ask limit orders represents the availability of liquidity provided by market participants and is an important dimension in explaining execution costs particularly when order size is considered.
- Bid-Ask Spread (BAS) – the difference between the highest price at which the buyer is willing to buy and the lowest price at which the seller is willing to sell. Often viewed as the cost to trade and measured in tick size, the minimum price movement of a contract. A narrow BAS is indicative of a liquid contract with low cost of trade, while a wide BAS is indicative of lower liquidity and a higher cost to trade. BAS shares a positive correlation with volume and a negative correlation with volatility.
- Resiliency – a market’s ability to handle and absorb large orders without significantly impacting price or liquidity.
During the roll, it is critical for hedgers and other market participants to understand how liquidity is provided today and the factors that affect it. Doing so can help reduce slippage and make better informed trading decisions. This paper looks to provide insights by examining how these factors along with changes in market fundamentals can affect roll liquidity in the Corn futures market.
Liquidity Today
Overall, the electronification of agricultural commodity futures has changed the way markets are traded and liquidity is provided. In 2018, 96 percent of total Corn futures volume was traded on CME Globex, CME Group’s electronic trading platform. Today, many traders and liquidity providers use technology to employ trading strategies that post limit orders on both the bid and ask sides of the market to gain the bid-ask spread (BAS). Similar to market makers in the open outcry trading pits, they arbitrage small price differences that emerge in the BAS, only at speeds incomparable with human action. When existing orders are cancelled, new limit orders from other liquidity providers immediately enter the market, leaving the top BAS unchanged.
Academic literature like Wang, Garcia, and Irwin (2014) suggests, with few exceptions, that the presence of these liquidity providers has contributed reliable liquidity to a larger number of market participants, driven down and stabilized lower liquidity costs, and increased price transparency in Corn futures markets. In fact, their findings could suggest that a low cost of liquidity (a narrow BAS) is essential for maintaining stable and liquid markets, as a one percent increase in the BAS was associated with a three percent decrease in volume and a one to two percent increase in volatility.1
While USDA report days tend to see higher intraday volatility as markets digest new and important information, Wang, Garcia, and Irwin’s (2016) and Hasbrouck’s (2013) working papers suggest that information shocks are less likely to be pronounced in deep and liquid markets.2, 3 The presence of liquidity providers enables other market participants to manage and react to market events in a cost-effective and efficient manner, while facilitating price discovery. During the roll, CBOT Corn futures spreads represent one of the deepest, most liquid markets around the world, as this paper will examine further.
Source: CME Group
While electronic spread trading volume in Corn futures markets accounts for a significant percentage of overall volume, Figure 1 demonstrates that it is concentrated in the months preceding contract expirations. During these months, spread trading volume accounts for approximately 57 percent of total volume on average. This suggests that roll months see elevated spread volume relative to other months of the year. In part, this can be contributed to the roll’s “sunshine effect.”
Sunshine trading occurs when high volume transactions are prematurely revealed to the market via public announcement (index rolls) or common knowledge (hedging) before the orders are entered.4 For example, the Goldman Sachs Commodity Index (GSCI) roll typically occurs on the fifth to the ninth trading day in the month prior to the expiration month.5 In effect, this signaled activity augments liquidity and attracts natural counterparties to the market, allowing market participants to prepare and position for the influx of volume in the nearby and deferred trading months without significantly impacting price.
Spread trading volume is highest in the months of February and November. This coincides with the March and December contracts, which are actively used for hedging because they reflect old and new crop year information, respectively. In contrast, August has lower spread trading volume because it precedes September. As a contract, September contains both old crop and new crop information, reducing hedging activity in the contract.
Source: CME Group
Figure 2 uses minute-level market data from the March-May Corn futures spread electronic limit order book to display and reconstruct and display the average resting order quantity in the top five levels of the book (left: bids in green and offers in red) during the roll period (one month prior to First Notice Day). On the right, the corresponding daily average BAS is plotted for each trading day in the March-May roll period, with a pink band delineating the 95 percent confidence interval. The larger the pink band, the larger the variance in the average BAS for that year’s roll.
A year-over-year comparison shows substantial growth in the resting available top-of-book liquidity. Since 2014, this growth has been accompanied by lower variance in the BAS, with a cost of trade held stable to 0.0025¢ per bushel, or one tick. Marked by the larger pink band and retracted average resting quantity, there was considerably less actionable liquidity and higher variance in the BAS for the March-May spread during the 2013 roll relative to other years. Looking at the March 2013-May 2013 spread in Figure 3 reveals how market fundamentals can impact liquidity.
Source: CME Group
Figure 3 above shows that the March 2013-May 2013 Corn futures spread became inverted during the roll period starting around February 8, 2013, with the March contract going from -2.00¢ under to 16.00¢ per bushel over for the May contract. In periodically produced storable commodities such as corn, inverted markets can occur when inventory is low and demand is high, which force near-term spot market prices to exceed future prices. Such conditions existed when the record-level drought in the summers of 2012 and 2013 devastated crop yields and created a supply shortage across the Midwest.
In inverted markets, prices are not tethered to storage, allowing more flexibility, and thus risk, as correlations along the commodity forward curve tend to diminish. This added uncertainty can lead to higher volatility, creating additional risk for liquidity providers and other non-commercial market participants. Under these riskier conditions, liquidity providers may be hesitant to lend their services, leading to a wider BAS and retracted bids and offers as seen in the year 2013 shown in Figure 3. For a traditional hedger or other market participant effectuating a trade during the roll, these fundamental market conditions can impact the cost of trade and lead to less certainty in execution given the lower state of liquidity.
Source: CME Group
Resiliency of the market, a key measurement of liquidity, is a market’s ability to handle and absorb large orders via the depth at the top of the book, ideally without any major impact on price. For example, in Figure 4, trading activity in the March 2019-May 2019 Corn spread, on February 22, 2019, demonstrates resiliency of the market to handle large orders with little to no impact on the bid-ask spread. The trading activity in dark gray shows that in little under a quarter of a second, approximately 38,000 contracts were traded, including back-to-back 5,000 lot and 2,500 lot trades, with no effect on the BAS. After the trading activity, the BAS maintains the minimum one tick increment between the lowest ask (red) and the highest bid (green) with no change in price. In physical equivalency, this represents 190 million bushels, or 4.8 million metric tons, flat-priced in under a second.
Conclusion
While the electronification of agricultural commodity futures markets has added liquidity and market participants from around the globe, there are still opportunities for traders to reduce execution costs, especially during the roll. By understanding the factors that affect liquidity and how liquidity is provided during this critical juncture, traders can better manage their short- and long-term price risks and avoid slippage.
The data examined in this paper shows that CBOT Corn futures spread markets at CME Group offer deep and stable liquidity during the roll, allowing buyers and sellers to act on displayed liquidity and enter and exit the market readily with large positions at low cost. For more information on the CME Group market liquidity please check out the CME Liquidity Tool.
- Wang, X., P. Garcia, and S. H. Irwin. 2014. The Behavior of Bid-Ask Spreads in the Electronically-Traded Corn Futures Market. American Journal of Agricultural Economics 96(2):557-577. https://experts.illinois.edu/en/publications/the-behavior-of-bid-ask-spreads-in-the-electronically-traded-corn
- Wang, X., P. Garcia, and S. H. Irwin. 2016. Are Agricultural Commodity Futures Getting Noisier? The impact of High Frequency Quoting in the Corn Market. Working paper, University of Illinois. http://www.farmdoc.illinois.edu/irwin/research/Wang_Garcia_Irwin_Oct%202016.pdf
- Hasbrouck, J. 2013. High Frequency Quoting: Short-Term Volatility in Bids and Offers. Working paper, University of New York. http://w4.stern.nyu.edu/finance/docs/pdfs/Seminars/1403f-hasbrouck.pdf
- Shang, Q., M. Mallory, and P. Garcia. “The Components of the Bid-Ask Spread: Evidence from the Corn Futures Market.” Proceedings of the NCCC-134 Conference on Applied Commodity Price Analysis, Forecasting, and Market Risk Management. St. Louis, MO. http://www.farmdoc.illinois.edu/nccc134/conf_2016/pdf/Shang_Mallory_Garcia_NCCC-134_2016.pdf
- S&P GSCI Commodity Index Roll Period. Goldman Sachs. https://www.goldmansachs.com/what-we-do/securities/business-groups/sts-folder/gsci/roll-period.html
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