Fundamental Analysis for Trading Futures

Stock traders know price is a function of fundamental factors—some internal, some external. Whether you’re a stock picker, scalper, swing trader, or anything in between, you likely keep an eye on some fundamental ratios—price to earnings, price to book, and cash flow, to name a few.

But what about futures? How do you track the fundamentals? There’s no price-to-earnings ratio on a barrel of crude oil.

Turns out, futures traders use a whole host of fundamental ratios to assess everything from short-term arbitrage opportunities to changes in long-term macro trends. Whether it’s crude, gold, bonds, or beans, you can watch a unique set of factors in each asset class. Even if you aren’t actively trading the futures markets, some of these ratios are still worth a look as secondary indicators that can offer insight into stocks, stock sectors, and the market as a whole.

Cracking the Code

Energy traders keep a keen eye on the crack spread—the difference in price between crude oil and the products derived from crude, such as gasoline, heating oil, diesel, and other distillates. Futures markets have their own version of the crack spread. The exchanges have designed contracts and contract sizes to roughly correspond.

One popular crack-spread ratio is 3:2:1—a spread of three contracts of crude oil (/CL) against two contracts of gasoline (/RB) and one contract of heating oil (/HO). The NYMEX heating oil contract serves as a benchmark for heating oil and ultra-low sulphur diesel fuel. Both terms are used interchangeably. Whatever you call it, a crack-spread ratio of 3:2:1 (or 5:3:2, 1:1, or whichever you choose) serves its purpose. Want to price it on the thinkorswim^® platform from TD Ameritrade? See Figure 1.

Sorry for the math, but here goes. A /CL contract is 1,000 barrels; /RB and /HO contracts are 42,000 gallons; and there are 42 gallons in a barrel. To get the spread price in dollars, multiply the price of /RB and /HO contracts by 42, then subtract the spot price for three barrels of /CL. So the formula for the crack per barrel is 0.33 (2*42*/RB+42*/HO–3*/CL). Enter that into the symbol box to see the crack-spread chart.

Why should you care? Because the crack spread ratio is an approximation of refinery margins, it can act as a proxy for the energy sector’s health and even the economy as a whole. Refiners are natural sellers of the crack spread—they buy crude oil and sell refined products—so a weakening crack spread can pressure oil refiners. For example, if there’s a disruption in the oil supply, it might weaken the crack. So might a slowing of economic growth. Seasonal trends, such as winter heating and summer travel, might strengthen the crack. So could a strengthening U.S. dollar, because it tends to weigh down crude oil prices.

Get a Load of Beans ‘n Corn

Like the proverbial beef-versus-chicken substitution curve from Econ 101, the soybean/corn ratio compares two somewhat interchangeable products. Think of it as the relative yield per acre of each crop, less the difference in production, marketing, and distribution costs. Corn yields about three times the number of bushels per acre, but it’s more expensive to grow, haul, and process.

At the beginning of each growing season, farmers decide what to plant. In the nation’s midsection, that typically means choosing between corn and soybeans. Once the crop is in the ground, there’s no turning back. In some years, the two crops move in tandem. In other years, growing conditions and demand dynamics can favor one or the other.

How do you plot a futures ratio on the thinkorswim platform, considering futures symbols include the “/” signifier, which doubles as a division sign? There’s a workaround: a lower study called PairRatio. To pull it up, under the Charts tab, go to Studies > Add Study/Quick Study > Lower Studies (Other) > PairRatio. In the chart box, type /ZS+/ZC. The ratio will appear in the lower section of the chart. To see just the ratio and not the sum of the two products in the upper half, go to Style >Settings and clear the Show price subgraph checkbox (see Figure 2).

The soybean/corn ratio compares bushels of soybean and corn values. Over the long term, the point of indifference has been about 2.3.

Why should you care? Tracking the soybean/corn ratio can offer clues about the state of the energy market, trade policy, and the macroeconomic environment generally. In addition to their function as animal feed, each can be converted into fuel—corn in the form of ethanol and soybeans in the form of biodiesel. Much like the crack spread, the soybean/corn ratio can also offer insight into the relative strength of energy refiners. More recently, the ratio has been used as a proxy for trade policy, specifically regarding U.S.-China relations. China has historically been a big importer of soy products, and negotiations typically include soybeans as a bargaining chip. So the ebb and flow of trade policy can, and does, affect the soybean/corn ratio.

Yield Curve Ratios That Measure It

If you follow traditional fundamentals, you’re likely familiar with the yield curve—the graphical representation of interest rates from the overnight federal funds rate, the 30-year Treasury bond, and all points in between. There are a number of ways you can track and spread the various points on the curve. But to do it, you’ll need to understand the ratios.

Treasury futures are quoted as a percentage of par value, rather than in basis points. But each contract can be roughly normalized to another in terms of the dollar value of a one-basis-point change (“DV01”) by means of a predetermined hedge ratio. Some of the more common include:

If you look at a chart of one of these formulas on the thinkorswim platform, a rising spread price indicates a steepening yield differential. If the price is decreasing, the yield spread is flattening.

Why should you care? A positive-sloping curve—shorter-dated maturities yielding less than longer-dated ones—is considered “normal” because longer maturities have more exposure to inflation and other risks.

In normal conditions, traders are compensated for the higher risk by earning a higher interest rate on longer-dated Treasuries. But sometimes the curve flattens out or even flips to the negative. When it does, it can be a sign of economic trouble brewing. It indicates traders are shifting from stocks and other riskier investments to the relative safety of the U.S. bond market.

Plus, the banking system relies on a positive-sloping yield curve. The traditional model is to pay interest on shorter-term deposits like checking accounts and CDs, while collecting interest on mortgages, auto loans, and other long-term commitments. So a flat or inverted yield curve could put pressure on the Financials sector.

Scratching the Surface

These are a few of the many ways you can use futures ratios for fundamental analysis. If you want to explore other ratios, there are plenty more out there. In the metals world, for example, you could plot gold—historically seen as an inflation hedge and overall safe haven—versus an industrial metal like platinum or copper. Or gold versus crude oil. And in the agriculture world, the venerable hog/corn ratio indicates more than pork production profitability; a rising ratio has also been shown to correlate with a strong consumer demand. And because we’re talking ratios, let’s not forget the foreign exchange market, which is made up of currency pairs—essentially the ratio of one nation’s currency to that of another’s.

Whether you’re tracking fundamentals as secondary indicators for the equity markets or trading futures products outright, ratios can become your friends. It’s a big, interconnected world out there. With ratios, it’s all relative.