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: 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: Reentry Signal Triggered

Back In the Rodeo

The IMC blog reentered the short side of the feeder/corn spread today when April feeder cattle broke support at last week’s low.

The short position was entered by selling one 50,000 lb. April feeder cattle contract at 158.325 (contract value of $79,162.50) and simultaneously buying five 5,000 bushel May corn contracts at $3.62 1/2 (a total contract value of $90,625). Therefore, the position is short from -$11,462.50 (premium the sum of the five corn contracts). The initial exit criteria will be to liquidate on a two-consecutive day close above -$6,462.50 (premium corn).

April Feeder Cattle weekly

April Feeder Cattle weekly

As noted in the prior post, the break below a previous week’s low in feeders would indicate that the bear market rally is over. The fact that it happened after testing resistance at the declining 50-day Moving Average (basis the nearest-futures) was already a good sign, but the fact that it resulted in an ‘outside bar’ with a downward reversal on the weekly timeframe is even better. If this is the resumption of the downtrend for the spread, we will be watching for opportunities to add to the position.

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.