Live Cattle/Lean Hog Spread: Liquidate April and Monitor December

Exit Stage Right

The IMC blog is holding a short position in the April live cattle/lean hog (x2) spread entered at the equivalent of -3.10 (premium hogs).  The trade was initiated on October 12th and rolled several times.

The April spread is trading around -1.50 (premium hogs) this morning and it needs to be liquidated as the contracts are about to expire.  Unfortunately, the June spread is trading around -32.00 and the August spread is trading around -38.00.  Due to the significant price discount of the summer spreads, it does not appear to be a lucrative trade.

December Live Cattle Lean Hog (x2) spread daily

December Live Cattle Lean Hog (x2) spread daily

The December live cattle/lean hog (x2) spread is trading at a more reasonable price of -11.50 (premium hogs), but it recently broke out to multi-month highs.  Therefore, our plan is to liquidate the April spread and wait patiently to see if a short sale setup might materialize in the December spread.

Trade Strategy:

On the hypothetical short April live cattle/lean hog (x2) spread entered at -3.10 (premium hogs), exit at the market-on-close on Wednesday, April 12th.

Cattle/Hog Spread: Waiting For the Next Pitch

One Strike, But We’re Still Swingin’

The IMC blog initiated a hypothetical short position in the February cattle/hog (x2) spread at 0.925 (premium hogs) on October 3rd when the February cattle/hog ratio closes below 2:1.

The spread was liquidated at 7.725 (premium cattle) on October 5th because the ratio made a two-day close at new highs for the move.  This resulted in a loss of -$3,460 on the trade.

live-cattle-lean-hog-ratio-nearest-futures-daily

Live Cattle Lean Hog ratio (nearest-futures) daily

The February contract ratio closed at a new contract high of 2.16:1 yesterday.  This places it right on the doorstep of potential technical resistance at 2.21:1, which is the major Fibonacci .618 retracement of the entire nearest-futures decline from the March 2015 all-time high of 2.76:1 to the June 2016 two-year low of 1.32:1.

If the nearest-futures cattle/hog ratio doesn’t peak somewhere around here, a test of the November 2015 secondary high at 2.46:1 is possible.

Regardless of where the ratio finally tops, we do know this: History shows that the ratio has been unsustainable above 2:1.  So despite the loss on this short sale attempt, the IMC blog still favors the short side of the February cattle/hog (x2) spread.  Therefore, we won’t hesitate to get right back into the position if the spread rolls over again.

february-live-cattle-lean-hog-x2-spread-daily

February Live Cattle Lean Hog (x2) spread daily

In light of this, the reentry setup we’ll employ is to get short on a break below the October 3rd reaction low where the first short sale attempt occurred.  Once again, we will simply risk to new highs afterwards.

Trade Strategy:

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 spread closes below 0.925 (premium hogs).  Initially, the spread will be liquidated if the ratio makes a two-consecutive day close above the contract high that precedes the entry, which is currently at 7.725 (premium cattle).

Cattle/Hog Spread: About Ready To Roll?

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.

live-cattle-lean-hog-overlay-weekly

live cattle lean hog overlay weekly

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.

live-cattle-lean-hog-ratio-nearest-futures-weekly

live cattle lean hog ratio (nearest-futures) weekly

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.

february-live-cattle-lean-hog-ratio-daily

February Live Cattle Lean Hog ratio daily

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.

february-live-cattle-lean-hog-x2-spread-daily

February Live Cattle Lean Hog (x2) spread daily

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.

Trade Strategy:

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).

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.

Feeder/Live Cattle Spread: Time To Take Profits

Corralling the Profits

The IMC blog is holding a short position in the November-December feeder/live cattle spread from the equivalent of +$41,820 (premium feeders). The November feeder contract expires next week, so we are going to go ahead and close out the position.

Still Heading South

Looking at the monthly timeframe, one can see that the feeder/live cattle spread has been in a downtrend since it peaked at a record high last year. There appears to be plenty of downside ahead. Therefore, we will now be monitoring the March-February feeder/live cattle spread for potential setups to get positioned back on the short side.

Feeder Cattle Live Cattle spread monthly (nearest-futures)

Feeder Cattle Live Cattle spread monthly (nearest-futures)

Trade Strategy:

The blog will exit the hypothetical short position in the November-December feeder/live cattle spread at the market-on-close today on November 10th.

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.

Feeder/Live Cattle Spread: Roll Out of the October Contracts

Rollover and Keep Riding the Bear Market

The blog entered a short position in the October feeder/live cattle spread at +$45,747.50 (premium feeders) on June 30th. October starts on Thursday so it’s time we roll this thing over.

Nov-Dec Feeder Cattle Live Cattle spread daily

Nov-Dec Feeder Cattle Live Cattle spread daily

The spread between November feeders and December live cattle is trading at a discount to the October spread. Nonetheless, the current level is still historically a good place to be short from. At a current price of approximately +$35k (premium feeders) we can expect another $10-15k of downside from here. Heck, anything above $15k used to be considered ‘pricey’ in the feeder/live cattle spread. Therefore, the ultimate destination of this spread could be significantly lower. Hopefully, we’ll see a few bounces of at $2-3K or more along the way. This could provide us with setups to add to the short position.

Ratio Confirmation

At today’s low of 1.65:1, the ratio between the value of one November feeder contract and one December live cattle contract is still at a level that has only been seen half a dozen times in the last half a century. This confirms that feeders are still historically overpriced in comparison to live cattle. The confirmation gives us a green light to maintain short positions and even add to them.

Nov-Dec Feeder Cattle Live Cattle ratio daily

Nov-Dec Feeder Cattle Live Cattle ratio daily

Based on the history of this ratio, it is not unreasonable to expect the ratio to return to 1.4:1 or lower. It has been two and a half years since the nearest-futures ratio has been this low. Previous monthly excursions above 1.4:1 were either side of two years in duration, so a return to 1.4:1 is overdue.

Feeder Cattle Live Cattle ratio monthly

Feeder Cattle Live Cattle ratio monthly

Furthermore, each time the ratio has reached 1.6:1 or higher it has always turned over and dropped back down to 1.3:1 or lower. It sort of acts like a pendulum where a run to one extreme end of the historic price range is often followed by a reversal that takes it back to the mean and beyond. This provides plenty of trading opportunities for the savvy spread trader.

Trade Strategy:

For tracking purposes, the blog will roll the October feeder/live cattle spread to the November feeder/December live cattle spread at the market-on-close on Tuesday, September 29th.