Welcome To the Meat Market
Historically, the cattle market and the hog market show a strong correlation in price trends. Not all the time, but enough to see an obvious relationship. This makes the relationship between the two meat markets a good candidate for spread trading.
The fact that there are some periods where the correlation weakens is actually a good thing. Trend followers can exploit the correlation breakdown and profit from the outliers, while knowledgeable spread traders can use such instances as an opportunity to start strategizing and getting themselves positioned for an eventual reversion to the mean.
Since peaking out in late 2014, the cattle and hog markets have pretty much trended in the same direction. The correlation is very high. Since there appears to be no divergence between the two markets right now, the question a trader might ask would be “Is there any worthwhile trading opportunity in the cattle/hog spread right now?”
The Ratio Says…
Looking at the last few decades of price history, it appears that the price of beef is too expensive once it costs at least double the price of pork. Note the weekly nearest-futures closing price of the cattle/hog ratio and you only see about half a dozen instances where the ratio ran to 2:1 or higher.
Furthermore, we also see that once the ratio surpasses 2:1 (where the price of cattle is more the double the price of hogs) it’s only a matter of time until the trend makes a major reversal and the ratio collapses. Usually it was only a matter of weeks until the top was established after surpassing 2:1.
As it turns out, the ratio between the February live cattle contract and February lean hog contract surpassed 2:1 just last week. More intriguing is the fact that the current ratio rally high of 2.05:1 is just slightly above price resistance at the October 29th high of 2.02:1.
If the ratio rolls over right here after clipping the October 2015 high, then it will trigger a Wash & Rinse sell signal for the February cattle/hog spread. This is a failed breakout pattern, which can lead to a sizable price reversal.
Since the ratio just reached 2:1, the blog will initially short one cattle contract and buy two hog contracts on a close back under 2:1. This will give us a more dollar neutral position.
If the ratio makes a new high after getting short, the position will be covered for a loss and new setup parameters will be issued. Most likely, reentering on a break to new correction lows would be the trigger point. At the same time, we will be cheering the spread on for a run to much higher levels in hopes that we see a new setup materialize at much higher (read unsustainable) price levels.
The blog will work a hypothetical order to sell one 50,000 lb. February live cattle contract and simultaneously buy two 50,000 lb. February lean hog contracts if the February cattle/hog ratio closes below 2:1. Initially, the spread will be liquidated if the ratio makes a two-consecutive day close above the multi-month rally high that precedes the entry (currently at 2.05:1).