Cattle/Hog Spread: Roll to the April Contracts

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.

Still Going

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.

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

Live Cattle Lean Hog ratio (nearest-futures) monthly

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.

Trade Strategy:

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.

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).

Feeder/Corn Spread: Back In a Bearish Bet

Headed South For the Winter

On September 6th, the IMC blog entered a short position in the Nov-Dec feeder/corn (x4) spread.  We sold a November feeder contract short at 126.075 (contract value of $63,037.50) and bought four December corn contracts at $3.28 1/2 (a sum contract value of $65,700), which puts us in the position at a price of -$2,662.50 (premium corn).

Initially, we are going to risk the trade to a two-day close above +$5,500 (premium feeders).  That’s nearly $500 above the August 30th contract high.

Bearish Technical Outlook

First of all, a double top pattern was formed between the August 9th high of +$4,962.50 and the August 30th high of $5,012.50.  Yesterday’s close below the August 19th low of +$237.50, which is the lowest point between the two highs, confirmed the pattern.

Secondly, the spread closed below the rising 50-day Moving Average for the first time since mid-June.

nov-dec-feeder-corn-x4-spread-daily

Nov-Dec Feeder Corn (x4) spread daily

Next, the nearest-futures spread closed above the widely-watched 200-day Moving Average at the start of August for the first time in a year.  This was a bullish event.  But here at the start of September, the nearest-futures spread closed back under the 200-day MA.  This could indicate that the party is over.

The spread should now be on its return trip to the mid-June low of -$23,650 (premium corn).  Based on history, a clean and sustained break of this low should clear the path for a descent to the -$40k area.  You can be that we’ll be watching for pyramiding opportunities if the bear market persists.

Live Cattle/Lean Hog Spread: An ‘Add-On’ Trade Was Elected. More To Come!

Just the Beginning?

Yesterday the December live cattle/lean hog spread closed below 80.00 (premium cattle) and triggered the ‘add-on’ entry criteria. Therefore, IMC blog sold another December live cattle/lean hog spread at approximately 78.65. Initially, we will liquidate the spread on a two-day close above 85.00.

Live Cattle Lean Hog ratio monthly

Live Cattle Lean Hog ratio monthly

Even though the ‘add-on’ was entered with the spread at a six-month low and the ratio at a three month low, the long-term charts indicate that we’ve barely scratched the surface of the potential bear market here. The December cattle/hog ratio closed at 2.22:1 yesterday. When you look at the last forty-five years of price history, you will see that there was only the fifth time that the ratio has ever been above 2:1! To get back somewhere close to normal, the ratio has a long, long way to go. This could be one heck of a trading opportunity if we can continue to add to the position as the trend unfolds. The IMC blog will be actively monitoring the situation to see if more ‘add-on’ short sale setups will materialize.

Feeders/Live Cattle Spread: The Short Sale Signal Was Triggered Today

Feeders/Live Cattle Spread

A lot has happened in the last eight days. Last week the October feeder/live cattle spread closed less than $100 away from the January 5th high of +$49,410, which is currently the high for 2015. Today it closed at a two-month low. Switching from a multi-month high to a multi-month low indicates that the tide has turned in favor of the bears.

Today’s close below price support at the May low of +$46,890 (premium feeders) triggered the hypothetical sell signal for the blog. A short position would have been initiated by selling one 50,000 lb. October feeder cattle at 212.075 (a contract value of $106,037.50) and simultaneously buying one 40,000 lb. October live cattle at 150.725 (a contract value of $60,290). This opens up a spread position at +$45,747.50 (premium feeders).

October Feeder Cattle Live Cattle spread daily

October Feeder Cattle Live Cattle spread daily

Initially, we will risk a two-day close above +$49,820. This is $500 above the June top.

As we’ve mentioned before, this spread has over $25k to go before it returns to a historically normal level. The October feeder/live cattle spread has a lot of profit potential on the downside. We will be watching to see how things unfold. If we’re lucky, a few countertrend rallies along the way may provide us with setups to add to the short position. We shall see.

Live Cattle/Lean Hog Spread: Short Sale Signal Triggered

Live Cattle/Lean Hog Spread

On Monday the December live cattle/lean hog spread closed at a new contract high of 95.12. Three days later, it closed at 91.85. This 3.27-cent pullback off the highs is the largest pullback that has occurred since the mid-April correction low was established. It also triggered the blog’s entry criteria to get short on a pullback of three cents (3.00 points) or more (on a closing-basis) from the watermark high.

The IMC blog made a hypothetical trade by selling one 40,000 lb. December live cattle contract at approximately 152.47 and simultaneously buying one 40,000 lb. December lean hog contract at approximately 60.62. This opens a short spread position at 91.85. Initially, we will liquidate the spread on a two-consecutive day close above 95.62 (.50 points above the contract high).

December Live Cattle Lean Hog spread daily

December Live Cattle Lean Hog spread daily

If the December live cattle/lean hog spread closes at a price of 92.85 or less today it will post the first weekly loss in nine weeks and alter the bullish price structure. This would corroborate the current overbalancing of price on the daily timeframe. After that happens, we will be pulling for a two-day close below the rising 20-day Moving Average (currently around 89.95) for the first time since the first half of May and a close back below the March 23rd top at 89.62 (old price resistance, once it has been broken, becomes new price support). Once this occurs, the bearish trend reversal in the December live cattle/lean hog spread should be solidified.

Trade Strategy:

The blog is still working 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 80.00 (premium cattle). Initially, risk the ‘add-on’ position to a two-day close above 85.00.

The price parameters for this ‘add-on’ trade could be changed if the price pattern between here and there lends itself to a better setup. We will certainly post an update if this turns out to be the case. It won’t be the only ‘add-on’ trade that we do, though. Since the 20-cent area is a historically normal level for the live cattle/lean hog spread to return to, we want to take full advantage of the bear market potential by actively looking for additional ‘add-on’ opportunities.

 

Feeders/Live Cattle Spread: Let’s Short the Halloween Spread If/When the Bulls Get Spooked!

Feeders/Live Cattle Spread

October Feeder Cattle Live Cattle spread daily

October Feeder Cattle Live Cattle spread daily

This morning the October feeder/live cattle spread traded less than $200 away from the January 5th high, which marks the current high for 2015. The spread has now clipped slightly above the Fibonacci .618 retracement of the entire decline from the mid-November contract high to the late February contract low. This would be a good place for a secondary top to form. Therefore, we are going to get our parameters in place to get short if the spread does reverse from here.

Feeder Cattle Live Cattle spread monthly

Feeder Cattle Live Cattle spread monthly

If we’re really lucky, the spread will continue to run higher and try to return to the contract high of +$53,720 before it turns lower. This would give us an opportunity to get short at an even higher level after a double top or a Wash & Rinse (failed breakout) pattern occurs. But since we don’t know where the top is or when the reversal will happen, it makes sense to go ahead and have a plan in place.

Feeder Cattle Live Cattle ratio monthly

Feeder Cattle Live Cattle ratio monthly

The surge over the last two and a half years has taken the feeder/live cattle spread to record highs. History shows that this spread is normally priced at less than half of the current levels. The current ratio of 1.8:1 in the October contracts is just off the record high as well. By both measures, feeders are way too expensive in comparison to cattle. Over the last several decades, the ratio has always reversed and gone back down to 1.3:1 or lower after reaching 1.6:1 or higher. Therefore, the short side of the feeder/live cattle spread is where informed spread traders should be focusing their efforts.

Trade Strategy:

The blog will work a hypothetical order to sell one 50,000 lb. October feeder cattle contract and simultaneously buy one 40,000 lb. October live cattle contract on a close below the May low of +$46,890 (premium feeders). Initially, the spread will be liquidated on a two-consecutive day close $500 above the watermark high of this rally that precedes the entry.

Live Cattle/Lean Hog Spread: The New Trade Setup

Live Cattle/Lean Hog Spread

The IMC blog entered a hypothetical short position in the December live cattle/lean hog spread at 83.50 (premium cattle) on April 15th and liquidated it at 85.75 (premium cattle) on May 28th for a hypothetical loss of $900. The position was liquidated early because of an upside breakout of a multi-week trading range. It seemed that the odds favored more upside, so it did not make sense to continue to hold the short position. Our plan was to get out and look for a setup to reenter after a run higher.

Just in case we got caught flat-footed and the spread collapsed right after we exited, we left the ‘add-on’ short sale order in place to sell on a break below the April correction low. That way, we would not have to worry about missing out if the bear market started.

December Live Cattle Lean Hog spread daily

December Live Cattle Lean Hog spread daily

As it turns out, covering the short position was the right thing to do. The December live cattle/lean hog spread rallied to a two and a half month high of 89.20 today, putting it just a stone’s throw from the March 23rd contract high of 89.62. This would be the perfect place for the spread to roll over and establish a double top. Better yet, it would be nice to see a Wash & Rinse sell signal where the spread pushes beyond the March high and then flips over. A failed breakout could be a more powerful sell signal than a classic double top since it would trap the buyers in on the wrong side of the market before the sell-off.

Furthermore, the ratio between December live cattle and December lean hogs firmed to 2.34:1 today. This brought it to the Fibonacci .618 retracement of the entire decline from the March contract high to the May multi-month correction low. This would certainly be a good technical level for the ratio to peter out.

December Live Cattle Lean Hog ratio daily

December Live Cattle Lean Hog ratio daily

Although the current levels would be ideal for the spread and the ratio to reverse, we have no idea if they actually will. Alas, we are currently out of batteries for our crystal ball (we’ve already ordered new ones on Ebay, as well as a new Flux capacitor for the DeLorean) and we’ve no confidence in the Magic 8-ball sitting on the trading desk. Therefore, we are going to have to rely on the old-school methods of the legendary trend followers and wait for a reversal before jumping back in.

Trend Change Signals

On the daily timeframe, the two largest pullbacks that the December live cattle/lean hog spread has experienced during this run from the mid-April low were approximately two cents (2.03 pts and 1.93 pts, respectively). Therefore, a pullback of three cents or more would be what is referred to as an ‘overbalancing of price’. Once that happens, the correction pattern on the daily chart is turned into a trend reversal pattern.

Also on the daily timeframe, the spread has closed above the rising 20-day Moving Average every single day for nearly a month. (Three more days will make it exactly one month). Therefore, a close below the 20-day MA (currently around 85.02) for the first time since May 12th would signal a potential trend change as well.

On the weekly timeframe, the December live cattle/lean hog spread has posted weekly gains for five consecutive weeks. Therefore, a weekly loss would alter this pattern and potentially signal a trend change.

Our strategy is to use one of these pattern changes to reenter a short position and use a break of the April low to double the position size. If the cattle/hog spread continues to fall from there we will look to continue adding to the short position to take full advantage of it.

Trade Strategy:

The blog will work a hypothetical 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 posts a weekly loss or makes a pullback of three cents (3.00 points) or more (on a closing-basis) from the watermark high, whichever occurs first. If filled, risk a two-day close .50 points above the contract high that precedes the entry.

Also, continue to 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 80.00 (premium cattle). If filled, risk the ‘add-on’ position to a two-day close above 85.00.

Feeders/Live Cattle Spread: Don’t Get Trampled In This Stampede!

Feeders/Live Cattle Spread

Since December 12th, the IMC blog has been holding a short position in the feeder/live cattle spread. After rolling over, the spread is currently short from the equivalent of approximately +$50,415 (premium feeder contract value) in the August contracts. (Note that we are looking at the difference between the values of the two contracts instead of the market prices. This will make it easier to track the P&L on the trade).

After the huge decline from the October peak to the late February multi-month low, the August feeder/live cattle spread rallied for a month and retraced to the midpoint of the decline. Nearly a month later, it had rolled over again and retraced more than half of the bounce. This should have put the spread on course for a break well below the February bottom.

August Feeder Cattle Live Cattle spread daily

August Feeder Cattle Live Cattle spread daily

Instead, livestock sector firmed from the April correction lows and stampeded higher. This sent the August feeder/live cattle spread running north as well. Yesterday’s close above the March peak was bullish and the spread has gone even higher today, putting the short position in the red for the first time since early January…and you know how things turn out when bulls see red! It currently does not pay to be holding a short position. We don’t want to “mess with the bull and get the horns” so let’s just exit stage right.

The position liquidation is just temporary. Spread traders should be prepared to jump back in once price complies.

October Feeder Cattle Live Cattle spread daily

October Feeder Cattle Live Cattle spread daily

Since we’re soon moving into the summer months, we will start watching the further out October spread instead of the August spread. It’s right on the doorstep of the current 2015 high that was posted on January 5th and it has recovered nearly two-thirds of the October-February decline. It certainly wouldn’t hurt our feelings to see the October feeder/live cattle spread score new 2015 highs and return to the November 18th contract high of +$53,720 (premium feeders) before it rolls over again.

Ridiculously Expensive

Remember that the difference between the value of a 50,000 lbs. of feeder cattle contract and a 40,000 lbs. of live cattle contract has historically been considered expensive when it reached a premium of +$15k! The explosive move higher over the last couple of years is unprecedented as the spread has rocketed into uncharted territory.

Feeder Cattle Live Cattle ratio weekly

Feeder Cattle Live Cattle ratio weekly

Using the ratio to normalize things reinforces this view that feeders are way too pricey in comparison to live cattle. The ratio between the October contracts touched a new high for 2015 this month when it closed at 1.8:1.   On the weekly nearest-futures chart, last year is the first time in history that the ratio has ever reached 1.8:1. Historically, it is considered ‘expensive’ once it reaches 1.6:1. The October ratio has never even been as low as 1.6:1 yet! Therefore, we know that the spread and the ratio remain at unsustainable levels. History shows that the ratio has always gone back down to 1.3:1 or lower after reaching 1.6:1 or higher. This is exactly why spread traders had better keep a close eye on the October feeder/live cattle spread. A new short sale signal is a high-probability trade that could offer some homerun returns.

Trade Strategy:

Buy back the one short 50,000 lb. August feeder cattle contract and simultaneously sell the one long 40,000 lb. August live cattle contract at +$51,000 (premium feeders) or better. Cancel any outstanding ‘add-on’ orders.