Live Cattle/Lean Hog Spread
The IMC blog entered a hypothetical short position in the December live cattle/lean hog spread at 83.50 (premium cattle) on April 15th and liquidated it at 85.75 (premium cattle) on May 28th for a hypothetical loss of $900. The position was liquidated early because of an upside breakout of a multi-week trading range. It seemed that the odds favored more upside, so it did not make sense to continue to hold the short position. Our plan was to get out and look for a setup to reenter after a run higher.
Just in case we got caught flat-footed and the spread collapsed right after we exited, we left the ‘add-on’ short sale order in place to sell on a break below the April correction low. That way, we would not have to worry about missing out if the bear market started.
As it turns out, covering the short position was the right thing to do. The December live cattle/lean hog spread rallied to a two and a half month high of 89.20 today, putting it just a stone’s throw from the March 23rd contract high of 89.62. This would be the perfect place for the spread to roll over and establish a double top. Better yet, it would be nice to see a Wash & Rinse sell signal where the spread pushes beyond the March high and then flips over. A failed breakout could be a more powerful sell signal than a classic double top since it would trap the buyers in on the wrong side of the market before the sell-off.
Furthermore, the ratio between December live cattle and December lean hogs firmed to 2.34:1 today. This brought it to the Fibonacci .618 retracement of the entire decline from the March contract high to the May multi-month correction low. This would certainly be a good technical level for the ratio to peter out.
Although the current levels would be ideal for the spread and the ratio to reverse, we have no idea if they actually will. Alas, we are currently out of batteries for our crystal ball (we’ve already ordered new ones on Ebay, as well as a new Flux capacitor for the DeLorean) and we’ve no confidence in the Magic 8-ball sitting on the trading desk. Therefore, we are going to have to rely on the old-school methods of the legendary trend followers and wait for a reversal before jumping back in.
Trend Change Signals
On the daily timeframe, the two largest pullbacks that the December live cattle/lean hog spread has experienced during this run from the mid-April low were approximately two cents (2.03 pts and 1.93 pts, respectively). Therefore, a pullback of three cents or more would be what is referred to as an ‘overbalancing of price’. Once that happens, the correction pattern on the daily chart is turned into a trend reversal pattern.
Also on the daily timeframe, the spread has closed above the rising 20-day Moving Average every single day for nearly a month. (Three more days will make it exactly one month). Therefore, a close below the 20-day MA (currently around 85.02) for the first time since May 12th would signal a potential trend change as well.
On the weekly timeframe, the December live cattle/lean hog spread has posted weekly gains for five consecutive weeks. Therefore, a weekly loss would alter this pattern and potentially signal a trend change.
Our strategy is to use one of these pattern changes to reenter a short position and use a break of the April low to double the position size. If the cattle/hog spread continues to fall from there we will look to continue adding to the short position to take full advantage of it.
The blog will work a hypothetical order to sell one 40,000 lb. December live cattle contract and simultaneously buy one 40,000 lb. December lean hog contract if the spread posts a weekly loss or makes a pullback of three cents (3.00 points) or more (on a closing-basis) from the watermark high, whichever occurs first. If filled, risk a two-day close .50 points above the contract high that precedes the entry.
Also, continue to work a hypothetical ‘add-on’ order to sell one 40,000 lb. December live cattle contract and simultaneously buy one 40,000 lb. December lean hog contract if the spread closes below 80.00 (premium cattle). If filled, risk the ‘add-on’ position to a two-day close above 85.00.