Live Cattle/Lean Hog Spread: The Bear Market Rally Could Be Another Short Sale Setup

The Livestock Spread Trade Campaign

On June 25th, the IMC blog initiated a short position in the December live cattle/lean hog spread at approximately 91.85. On September 2nd, an ‘add-on’ position was initiated with another short sale at 78.65. This doubled the position size for three reasons:

First, history indicates that the live cattle/lean hog spread usually returns to the 20-cent area. After this summer’s reversal from the top, the spread has a long ways to go to hit the target. So we want to add to the position as the trend unfolds and squeeze as much as we can out of the move.

Second, the open profit in the initial position was large enough to allow us to double our exposure and risk only a portion of the open profits.

Third, the reward-to-risk expectation for the ‘add-on’ position was either side of 10-to-1. Even if this was an initiating trade instead of an increase in position size the probabilities and the reward-to-risk ratio would still qualify this as an outstanding trade setup.

Another Adding Opportunity

On September 30th the December live cattle/lean hog spread breached price support at the July 16th low. It then recovered quickly and has rallied a little over six and a half cents off the new contract low so far. This temporary support breach and bear market rally has provided us with a setup for another ‘add-on’ position.

December Live Cattle Lean Hog spread daily

December Live Cattle Lean Hog spread daily

During the three-month decline, the spread made two notable bounces. A 520-point bounce off the late June low was followed by a decline to lower corrective lows and a 590-point bounce off the late July low was also followed by a decline to lower corrective lows. Therefore, it would be symmetrically fitting to see the recent rally off the late September low be followed by a break to new contract lows. This is a nice setup for a second ‘add-on’ position.

Big Picture Trading

On the one hand, it can be argued that the live cattle/lean hog spread is very oversold. A quick glance at the daily chart shows that it only took three months to collapse from the contract high to the current contract low.

On the other hand, when we zoom out to a longer timeframe and see where this livestock spread has been over the last forty-five years, it appears that the bearish trend change off this year’s record high may just be the beginning of a major decline. The new bear market is just a cub!

Live Cattle Lean Hog spread weekly

Live Cattle Lean Hog spread weekly

The current contract low for the December live cattle/lean hog spread is 64.20. This is more than triple the median spread price (our minimum expected objective) of 20 cents. As you can readily see on the charts, last year is the first time in nearly half a century of price data that the spread has ever been as high as 64.20 (the red dashed line). Therefore, a break to new contract lows in the December spread could keep the spread in freefall mode. It seems like a good opportunity to increase the position size again by adding another spread if the breakdown continues.

Trade Strategy:

The blog will 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 64.20 (premium cattle). Initially, risk this ‘add-on’ position to a two-day close .50 points above the October high that precedes the entry.

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