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: 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.

Feeder/Corn Spread: Will the Breakout Last?

Sidelined

The IMC blog entered a short position in the feeder/corn spread on January 8th.  After a series of rollovers and ratio adjustments, the last position was a Nov-Dec feeder/corn (x4) spread short from the equivalent of -$1,237.50 (premium corn).

The spread was liquidated at +$3,775 (premium feeders) on August 4th, resulting in a loss of -$5,012.50.

The Current Stampede

The Nov-Dec feeder/corn (x4) spread posted a new contract high of +$3,837.50 (premium feeders).  The nearest-futures spread is at even loftier heights as it reached a nearly seven-month high of +$10,025 (premium feeders).  This is bullish.

Feeder Corn (x4) spread (nearest-futures) daily

Feeder Corn (x4) spread (nearest-futures) daily

With the nearest-futures spread clearing the widely-watched 200-day Moving Average for the first time in a year, the door is open for a run to the midpoint of the entire bear market decline from the 2014 all-time high.  This would put it somewhere in the neighborhood of +$18,500 (premium feeders).

Feeder Corn ratio (nearest-futures) weekly

Feeder Corn ratio (nearest-futures) weekly

Furthermore, the nearest-futures feeder/corn ratio is back up to 4.6:1.  Recall that the ratio is historically extreme and unsustainable when it gets above 4.8:1 (nearly five-to-one).  In the past, ratio peaks above 4.8:1 have been followed by declines back below 3:1.  This last bear market only made it to 3.14:1.  So keep your eyes open.

Who’s the Sucker?

Since the Nov-Dec feeder/corn (x4) spread is at new record highs and still trading at a discount of several thousand dollars to the nearest-futures spread, there’s plenty of upside potential.

Nov-Dec Feeder Corn (x4) spread daily

Nov-Dec Feeder Corn (x4) spread daily

However, markets sometimes breakout and suck everyone in before rolling over and crushing the unsuspecting.  Now that the spread has broken out to new contract highs, a close back below support at the July 29th pullback low of -$925 (premium corn) and a close below the rising 20-day Moving Average (currently around -$1,045) for the first time since mid-June could be a strong clue that this breakout attempt was a sham.  If so, it might be worth taking a crack at the short side again.

Trade Strategy:

Place a hypothetical order to sell short one 50,000 lb. November feeder cattle contract and simultaneously buy four 5,000 bushel December corn contracts if the Nov-Dec feeder/corn (x4) spread closes below the July 29th low of -$925 (premium corn).  If filled, risk a two-day close $500 above the contract high that precedes the entry.

Feeder/Corn Spread: Adjust the Spread for the Ratio

Recalibrate

The IMC blog is currently holding a short position in the August-September feeder/corn (x5) spread.  Due to a prior rollover, the spread is short from the equivalent of -$15,325 (premium the sum of the five corn contracts) on January 8th.

The spread has made a monster-size rally over the last three weeks as the corn market fell on its ear.  With a summer delivery contract in feeders, we’re now looking to roll into further out contracts.  In addition, the ratio of the spread is going to be adjusted.

At this week’s high, the ratio between the value of one November feeder contract and one December corn contract closed just above 4:1.  This matched the April high of 4.02:1 and was just a tad beyond the March high of 4:1.  The high for the year, set on January 4th, was only a bit further at 4.16:1.  By all appearances, it would seem that the ratio is at stiff resistance.

Nov-Dec Feeder Corn ratio daily

Nov-Dec Feeder Corn ratio daily

Looking at the last forty-five years of monthly closing prices, a ratio of 4:1 is a high level.  And keep in mind that it’s just coming off of an all-time high of 7.34:1!  There should be more downside ahead.

To normalize the spread between feeders and corn when the ratio is 4:1, you need to spread one feeder contract against four corn contracts.  Therefore, the blog is going to roll to the November-December spread and adjust the ratio down to normalize.

Trade Strategy:

Buy back the one 50,000 lb. August feeder cattle contract and simultaneously sell short one 50,000 lb. November feeder cattle contract at the market-on-close on Friday, July 8th.  Also, sell the five 5,000 bushel September corn contracts and simultaneously buy four 5,000 bushel December corn contracts at the market-on-close on Friday, July 8th.

This will roll the short Aug-Sep feeder/corn (x5) spread position into a short Nov-Dec feeder/corn (x4) spread position.  Risk the Nov-Dec spread to a two-day close above +$3k (premium feeders).

Feeder/Corn Spread: It’s Rollover Time!

Time to Roll

The IMC blog entered a short position in the April-May feeder/corn (x5) spread at -$11,462.50 (premium the sum of the five corn contracts) on January 8th.  Since the First Notice Day for both of these markets hits next week, it’s time to roll over.

At yesterday’s new contract low of nearly -$24k, it would appear that the April-May feeder/corn (x5) spread has already declined enough.  However, history indicates that the spread could still have significant downside ahead.

First of all, the spreads prior excursions to ‘even money’ or better (where one feeder contract was worth at least the same value as the sum of five corn contracts) were followed by multi-month/multi-year declines to -$50k, -$38k, and -$133k (!).

Feeder Corn (x5) spread (nearest-futures) weekly

Feeder Corn (x5) spread (nearest-futures) weekly

In addition, the ratio between a 50,000 lb. feeder cattle contract and a 5,000 bushel corn contract is a little under 4:1 today.  The normal level for the ratio is somewhere around 3:1.

The ratio peaked at an eye-popping record high of nearly 7.5:1 about a year and a half ago.  It has been working its way lower since.  Prior peaks near 5:1 or higher were followed by declines that put the ratio below 3:1.  The 1987 peak of 4.98:1 was followed by a decline to nearly 2:1 the following year and the 2005 peak of 6.15:1 was followed by a decline to 1.5:1 over the next two and a half years.

To reach a ratio of 3:1, the feeder/corn (x5) spread would have to decline to somewhere between -$39k and -$50k.  That’s another $18,000 to $28,000 from where the spread sits today.  And if the ratio is heading to 2:1 or lower…well, I’ll let you do the math on that.  It’s certainly worth your while to be short.

We are going to roll the position to the August-September spread.  We will also monitor the spread vigilantly for setups to add to the position.

Trade Strategy:

Buy the one 50,000 lb. April feeder cattle contract and simultaneously sell one 50,000 lb. August feeder cattle contract at the market-on-close on Friday, April 22nd.  Also, sell the five 5,000 bushel May corn contracts and simultaneously buy five 5,000 bushel September corn contracts at the market-on-close on Friday, April 22nd.  This will roll the short April-May feeder/corn (x5) spread position into an August-September feeder/corn (x5) spread position.  Risk the August-September spread to a two-day close above -$9,000 (premium the sum of the five corn contracts).

Feeder/Corn Spread: Setup For a Reentry

Still Riding the Bear

The feeder/corn spread topped out at a historic high fifteen months ago. Since then, IMC has been in and out of this spread on the short side as we’ve tried to capitalize on the bear market.

Feeder Corn ratio (nearest-futures) monthly

Feeder Corn ratio (nearest-futures) monthly

The normal ratio between a 50,000 lb. feeder cattle contract and a 5,000 bushel corn contract is somewhere around 3:1. It peaked at a record high of nearly 7.5:1 in Q4 of 2014 and has been stair-stepping its way lower ever since. In nearly half a century of price data, there have been about half a dozen times when the nearest-futures feeder/corn ratio has been at 4.8:1 (nearly five-to-one) or higher. The prior runs to this level have ultimately been followed by a return to 3:1 or lower. Therefore, we continue to look for short sale opportunities as the trend progresses on a south-bound trajectory.

Ready to Roll

After posting a new contract low in mid-December, the feeder/corn ratio made a sharp rebound into year-end. It was due to a combination punch of the rally in livestock, prompted by position-squaring of short positions and cold weather finally arriving in the US, and the corn market falling on its ear as concerns of El Niño fade away while supplies remain abundant. The momentum is continuing here in the first trading week of 2016.

The bearish macro fundamentals remain in place. After the US drought wiped out supplies and sent the cattle market stampeding to record highs, cow herds started to expand again in 2015. This is expected to continue in 2016, while US exports are already at multi-year lows and imports are at multi-year highs.

On the feed side of the spread, corn prices have pretty much been in a trading range over the last year. Large supplies have capped the upside, but demand has materialized several times when the market dipped below $3.50-per-bushel.

This scenario makes us think that this recent price recovery in the spread is merely a bear market rally and, therefore, a selling opportunity.

Consulting the Charts

From a technical perspective, the recent price action indicates that the bounce is now testing resistance levels.

Over the last three years, the best way to make money in the feeder cattle (basis the nearest-futures) was to be long on a long on a close above the 50-day Moving average and short on a close below the 50-day Moving average. This trend reversal signal has been highly accurate.

Feeder Cattle (nearest-futures) daily

Feeder Cattle (nearest-futures) daily

After a bearish trend change signal was triggered last June, the 50-day MA has provided resistance for feeders. The 21.65 cent bounce off the October low ended after the market tagged the 50-day MA. A decline to new bear market lows followed. Currently, feeders have rallied a little over 26 cents off the December low and they are pushing on the 50-day MA. A reversal from here would be a low-risk selling opportunity. However, a two-day close above the 50-day MA for the first time since June would trigger a bullish trend change signal. This should not be ignored. We’ll let the market tell us if we should get short or not.

April Feeder Cattle weekly

April Feeder Cattle weekly

April feeders have made higher weekly highs for three consecutive weeks and it is now approaching the Fibonacci .618 retracement of the leg down from the October bounce. If the contract does not trade to 158.45 or lower by Friday, this will also be the third consecutive week with higher weekly lows. This is turning into bullish price structure. However, a break below a prior week’s low would negate that and indicate that the bear market in feeders is continuing. A break below a prior week’s low might be a good short sale signal. It certainly worked out that way after the rally crested in October.

The nearest-futures corn contract dropped to a four-month low of $3.50 1/4 to kick off the New Year. This puts it within striking distance of price support in the $3.40s. The market bottomed in this area in May, June, August, and September of 2015, so it represents the bottom of a trading range.

Corn (nearest-futures) daily

Corn (nearest-futures) daily

The catch is that we’re watching the May futures contract for the trade. May corn has made new contract lows in three of the last four weeks as it bleeds off the carry-charge. It may also make lower weekly highs for the fourth-consecutive week. This is bearish price structure. Therefore, it might take a breakout above a prior week’s high to indicate that corn is ready to pop again.

Spread Behavior

Now that we’ve taken a peek at the feeder market and the corn market, the next logical step is to examine the price action of the spread and the ratio.

April-May Feeder Corn (x5) spread daily

April-May Feeder Corn (x5) spread daily

The April-May feeder/corn (x5) spread traded just past the October peak this morning. So far, the spread has rallied a little more than $16,000 off the contract low. This was noticeably more than the $11,487.50 rally from the early October low, but not quite as much as the $18,437.50 rally off the mid-July low. Based on the size of the current rally and the price level, we can probably say that the spread has reached a resistance area. If it rolls over from here, especially after testing resistance at the prior bounce high, a short sale makes sense. If it does not roll over, the spread may advance toward psychological resistance at the ‘even money’ mark next.

April-May Feeder Corn ratio daily

April-May Feeder Corn ratio daily

The April-May feeder/corn ratio reached a two-month high of 4.61:1, putting it just below the October peak at 4.65:1. The bounce is about the same size as the bounce from the mid-July low. This is an ideal place for a reversal. Conversely, a sustained close above 4.65:1 could clear the way for a stampede toward the August high of 5.12:1. Our thoughts remain consistent: Short the spread if it starts to roll over, stay patiently on the sidelines if it does not. Once we get back in, we’ll be looking for setups to add to the position.

Trade Strategy:

The blog will work a hypothetical order to sell one 50,000 lb. April feeder cattle contract and simultaneously buy five 5,000 bushel May corn contracts if April feeder cattle trades .15 below a prior week’s low. Initially, the spread will be liquidated on a two-consecutive day close $500 above the multi-month rally high that precedes the entry (currently at -$7,137.50).

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.