When Pigs Trump Cows
On October 12th the blog initiated a theoretical short position in the livestock markets by selling one February live cattle contract at 99.525 and simultaneously buying two February lean hog contracts at 50.925. This positioned us in the spread at a price of -2.325 cents as the sum of the price of two hog contracts was worth about two and one-third of a cent more than the price of one cattle contract.
We got into the position when the ratio was just below 2:1. As you recall from an earlier post, there were only about half a dozen times in the last few decades where the cow/pig ratio made it as high as 2:1 or more. Therefore, we figured a short sale after peaking above 2:1 would put the historical odds in our favor as we bet that the hog market would start to outperform the cattle market.
Yesterday the February cattle/hog ratio closed at a low of 1.63:1, matching the contract low set back in June. Things are going well! The problem is that the February contracts go off the board in a few days. That means we have to book the trade or roll over.
So what to do?
First of all, consider the fact that all but one of the declines that started from a peak of 2:1 or higher took the ratio below 1.1:1. The one exception still took the ratio below 1.4:1. Therefore, history implies that the bear market is not close to finished yet. So it makes sense to stay short as long as the downtrend is still intact.
Secondly, we have to consider the rollover costs. The April cow/pig ratio closed at a multi-month low of 1.62:1 yesterday and the June cow/pig ratio closed at a multi-month low of 1.34:1. That April ratio is similar to the closing price of the February ratio of 1.63:1, but the June ratio is significantly below the closing price of the February ratio. Based on this, it makes sense to roll to the April spread to get a couple more months of time out of the trade, but it does not make sense to think about switching to the June spread yet.
On the hypothetical short February live cattle/lean hog (x2) spread entered at -2.325 (premium hogs), roll to the April contracts at the market-on-close on Tuesday, February 7th.