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Commodity Spreads 14: What is Seasonality?

16 May 2018,

After thirteen parts of the spread series, we have the perfect base for trading commodity spreads. Now we can go to the specific analyzes I use when selecting the right trade. In the last part I have partly started with seasonality and I will continue with it also today. There is no doubt seasonality is part of the spread trading. Paradoxically, however, I consider it a second-line factor for selecting specific spreads. In the following parts, I will explain why.

Seasonality and weather

Seasonality is basically very simple and very directly related to our lives. The first typical example is the temperature change during a year that affects each of us. I’ll connect it for example with home heating. Winter is the coldest and our heating costs are logically the highest. In the spring, we expect temperatures to gradually rise. Our heating costs will therefore decrease. In the summer the temperatures are highest, and in general we do not have to heat at all. In the autumn, however, a colder period begins again, and expenses are rising again. In this way, it is repeated every year. I do not talk about exact daily changes! Or about accurate temperature values ​​in specific months.

Seasonality and tomatoes

Another favorite example is tomatoes, more precisely their prices. You have certainly noticed that tomatoes are the most expensive in the winter. There is no growing season. Most tomatoes are imported, which is also reflected in their price. On the contrary, in the spring, when the local producers begin to supply more vegetables to supermarkets, prices tend to fall gradually. During summer, the price is lowest, because there is plenty of tomato everywhere. Here again, this price tends to be repeated every year. In tomatoes I also do not talk about specific prices, only about change and price movement.

Seasonality and commodities

The same matters for commodities. The more commodity is supplied to the market, the lower is the price. Conversely, when there is a less commodity on the market (or demand exceeds supply), the price increases. This is the essence of the movement of commodity prices and at the same time a basis for understanding seasonality. Precisely speaking, it is a cyclical repetition of the uneven distribution of supply and demand over time.

Typical example of supply fluctuations during the year can be seen on grains. In the previous work we talked about corn. On the term structure we have showed its cyclic waves due to new harvests. In the case of demand, a typical example is considered gas or heating oil. The gas term structure can be seen in the following chart. Repetitive significant waves are evident at first glance. Note that the market expects the highest gas prices in the winter months due to increased demand due to heating.

 

 

Once we talk here about changes in supply, other time about changes in demand. But both are influenced by one thing – climate. The seasonality is caused by various influences. But the most important are weather changes. That’s why seasonality works so well. Because it is based on natural cycles. But you need to be very careful about the right way how to understand it. Seasonality works well within a very approximate period. It does not work exactly on daily bases. Or sometimes it may not even show up at all. It is not guaranteed that tomatoes will be the cheapest tomorrow or that the first snow will come on December 1st.

 

Right from the start, when examining seasonality, it is very important to realize this fact. Many traders, however, use only seasonality and have the whole trading system based on it. I certainly do not want to underestimate the importance of seasonality. Based on this, many different procedures and methods have been developed to optimize the entry or exit from the trades. But the seasonality itself is not enough for me!

 

What can you expect next time?

Next time, we will continue to explore the seasonality. Its use is simple, but there are a few other things I would like to tell you. For example, what charts should you watch and how I work with them.

 

 

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