Meat Futures Spreads (introduction)

You're probably asking yourself meat futures? Why? What is so interesting with those futures? The answer is not simple, so I will go slowly. I'm sure that your interest will grow as you progress in your reading. 

 In this first article I'll start explaining some of the characteristics of meat futures that have made me be interested in them. These are the futures on which I base most of my trading: 

 - Cattle Feeder: calves with an average weight of 769 pounds (349 kgs.). The average weight comes from dividing the total weight of the futures contract (50,000 pounds) between the number of animals of the contract (65). Each point is worth $ 500. Symbol: GF 

 - Live Cattle: cattle which have reached slaughter weight. This weight is 1,250 pounds (567 kgs.). The average weight is calculated by dividing the weight of the contract (40,000 pounds) among the 32 cattle contract. Each whole point is $ 400. Symbol: LE. 

 - Lean Hogs: Contracts are 40,000 pounds of pig carcasses. Each whole point is $ 400. Symbol: HE. 

The Feeder Cattle evolve, after several months, in Live Cattle. If we include in the equation the main food is needed for this transformation (corn), we have a nice spread, Cattle Crush. This spread recreates with a synthetic form of futures contracts, the passage of an animal that begins the fattening phase until it reaches its final weight. 

 This graph shows the evolution of Feeder Cattle in the past 35 years, is it interesting?

In the table below, I have marked in yellow the expiration months for each meat futures contract:

Subsequent articles will examine how to take advantage of this peculiar distribution of months available for each type of contract.

These futures are largely unknown by speculators compared to other products. They seem an exotic and difficult to understand product. However, they have several advantages.

First, we must mention as one of its best qualities, seasonality. This seasonality depends on the main livestock feed (corn) and varying times of meat consumption. In Live Cattle, for example, the maximum production coincides with the months of May and June. However, in August and September the number of sacrifices is the lowest.

In the case of Lean Hogs, peak production is in the months of November and December. This is because the price of corn is cheaper at harvest time (October and November). Thus, producers have the cheapest food over the last two to three months of the feeding process, which is when animals consume more. Also keep in mind that in the months of higher temperatures, meat conversion is the lowest.

Seasonality can be affected by adverse weather conditions, diseases, crop conditions ... Sometimes, when everything goes according to established patterns, there can be a major surprise and change the setup in hours or even minutes. If this type of situation is identified, you have to react fast.

It will be better to explain with an example. This is the butterfly chart (combination of three lean hogs futures contracts: may, june and july) Lean Hogs HE KMN4:

It seems that everything is under control, Seasonal bias is clearly bullish. If we are patient and we bought in the minimum area, it seems very easy to make money. However, in the next picture we see what happened next. If someone came up to average down as it was coming to the supports, chances are this trader is not already participating in the market. And there were operators who made a lot.

Another advantage, in my opinion, has to do with the publication of reports of the USDA (United States Department of Agriculture). In the case of cattle, Cattle on Feed report is published on a monthly basis. For pigs, the report is quarterly: Quarterly Hogs and Pigs. These reports are about the census, the number of animals that have entered in feeding farms, heads marketed, etc. In addition, on page USDA there is a an stunning amount of information with high quality.

In my case, I study charts first and then seek explanations on fundamental reasons, to assess the subsequent evolution of the graphics.

My usual operations with these future is the use of spreads (simultaneous purchase and sale of two or more contracts). These spreads are formed with two or three legs (maturity) of the same future.

An example of spread with two legs: Long Short HE HE February and April

An example of butterfly (three legs or maturities): Long HE June, Short HE July (two contracts) and long HE August.

Sometimes I trade the spread between different futures, Live Cattle and Lean Hogs. Since there are two different contracts, this spread can be very volatile.

When I´m trading spreads, I combine technical analysis with the study of that spread´s seasonality in previous years. Seasonality can be analyzed for different periods of time, five years, ten years, fifteen years ... The strength of seasonality of a spread will be greater the longer the period of time in which a behavior has been repeated.

In future posts, I will continue to progress in other related topics about meat futures: method of choice of spreads, butterflies and cattle crush.

This article was originally published in my Spanish blog: Spreads con futuros de carne (introducción)

I have prepared all charts with:Scarr Visual Trading