Feeders/Live Cattle Spread
Since December 12th, the IMC blog has been holding a short position in the feeder/live cattle spread. After rolling over, the spread is currently short from the equivalent of approximately +$50,415 (premium feeder contract value) in the August contracts. (Note that we are looking at the difference between the values of the two contracts instead of the market prices. This will make it easier to track the P&L on the trade).
After the huge decline from the October peak to the late February multi-month low, the August feeder/live cattle spread rallied for a month and retraced to the midpoint of the decline. Nearly a month later, it had rolled over again and retraced more than half of the bounce. This should have put the spread on course for a break well below the February bottom.
Instead, livestock sector firmed from the April correction lows and stampeded higher. This sent the August feeder/live cattle spread running north as well. Yesterday’s close above the March peak was bullish and the spread has gone even higher today, putting the short position in the red for the first time since early January…and you know how things turn out when bulls see red! It currently does not pay to be holding a short position. We don’t want to “mess with the bull and get the horns” so let’s just exit stage right.
The position liquidation is just temporary. Spread traders should be prepared to jump back in once price complies.
Since we’re soon moving into the summer months, we will start watching the further out October spread instead of the August spread. It’s right on the doorstep of the current 2015 high that was posted on January 5th and it has recovered nearly two-thirds of the October-February decline. It certainly wouldn’t hurt our feelings to see the October feeder/live cattle spread score new 2015 highs and return to the November 18th contract high of +$53,720 (premium feeders) before it rolls over again.
Remember that the difference between the value of a 50,000 lbs. of feeder cattle contract and a 40,000 lbs. of live cattle contract has historically been considered expensive when it reached a premium of +$15k! The explosive move higher over the last couple of years is unprecedented as the spread has rocketed into uncharted territory.
Using the ratio to normalize things reinforces this view that feeders are way too pricey in comparison to live cattle. The ratio between the October contracts touched a new high for 2015 this month when it closed at 1.8:1. On the weekly nearest-futures chart, last year is the first time in history that the ratio has ever reached 1.8:1. Historically, it is considered ‘expensive’ once it reaches 1.6:1. The October ratio has never even been as low as 1.6:1 yet! Therefore, we know that the spread and the ratio remain at unsustainable levels. History shows that the ratio has always gone back down to 1.3:1 or lower after reaching 1.6:1 or higher. This is exactly why spread traders had better keep a close eye on the October feeder/live cattle spread. A new short sale signal is a high-probability trade that could offer some homerun returns.
Buy back the one short 50,000 lb. August feeder cattle contract and simultaneously sell the one long 40,000 lb. August live cattle contract at +$51,000 (premium feeders) or better. Cancel any outstanding ‘add-on’ orders.