Live Cattle/Lean Hog Spread: Let’s Take the Money and Run

Time to Go Vegan

On June 25th, the IMC blog initiated a short position in the December live cattle/lean hog spread at approximately 91.85. We then doubled up with another short sale at approximately 78.65 on September 2nd.

We think it may be time to get out of this meat spread for two reasons. First, we are coming into a seasonal time window where the cattle/hog spread normally rallies sharply. The spread has a tendency to rally from just after Thanksgiving to right around Christmas.

Typically, the trend in the livestock market is bearish between late November and late December. But the live cattle/lean hog spread rallies because the pigs usually fall fast than the cows.

Price Action Matters

The second -and more important- reason that we want to ‘go vegan’ with our meat spread is because of the price action.

After posting a new contract low at the end of September the December live cattle/lean hog spread surged for about a month. For the first time since early August the spread closed above resistance at the 50-day Moving Average. This indicated that the trend had turned bullish on the daily timeframe.

Also, the rally off the September low was substantially larger than all the prior bounces on the way down. Symmetrically, this is known as an ‘overbalancing of price’ and is one characteristic of a trend change.

December Live Cattle Lean Hog spread daily (50-day MA)

December Live Cattle Lean Hog spread daily (50-day MA)

The rally peaked near the Fibonacci .618 resistance line at the start of November and began to retreat. At yesterday’s close, the spread had surrendered nearly half the rally and dipped just under the 50-day MA (this prior resistance level became support once it was broken in October). Now that it’s starting to bounce this morning, it looks like a buy signal. At the very least, it would suggest that it’s time to cover our shorts.

On the weekly chart, the early July 2014 low of 67.00 was major price support. This level was broken by a full point during the last week of September when the spread closed at 66.00. The spread exploded higher the very next week, triggering a Wash & Rinse buy signal (failed bearish breakout). This corroborates the bullish trend reversal on the daily timeframe.

December Live Cattle Lean Hog spread weekly

December Live Cattle Lean Hog spread weekly

Looking at the December cattle contract on its own merit, a Wash & Rinse buy signal was triggered there as well. Yesterday the market clipped below the October 1st contract low. Today it is up sharply. This is not a time when you want to be short.

Stay Macro, My Friend

Although we are cashing in our chips on the current position, keep in mind that the live cattle/lean hog spread is still it levels that have been historically unsustainable. This means that the macro trading strategy should still be focused on the short side of this spread.

A ratio normalizes a spread relationship, so we always like to take a look at it for confirmation. Regarding the cattle and hogs, the ratio still indicates that the beef/pork spread is, indeed, still way out of whack with what is considered normal.

Live Cattle Lean Hog ratio weekly

Live Cattle Lean Hog ratio weekly

Recall from previous posts that beef is just too expensive when cattle are priced at double the price of hogs. Another way of saying this is that pork is too cheap when the cattle/hog ratio is 2:1 or higher. Either way, history shows that looking for a reversal signal somewhere above 2:1 has yielded some great short sale opportunities. At 2.44:1, the nearest-futures cattle/hog ratio is at levels only seen a couple of times in the last half century. So although we may be pulling our horns in right now, you can bet that we will be looking for a setup to short the live cattle/lean hog spread once again.

Trade Strategy:

On the short December live cattle/lean hog spread entered at approximately 91.85 and the short December live cattle/lean hog spread (the ‘add-on’ position) entered at approximately 78.65, exit right here at 75.50 or better. Also, cancel the hypothetical ‘add-on’ order to sell another spread on a close below 64.20.

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