Meat Futures Spreads (part two)

In this second article about meat futures, I'll start with general aspects for any spread and I will end up focusing on meat futures.

When seeking a combinations of two futures, I look for the following:

1- Avoid futures that are suffering extreme conditions. We want a combination of future contracts that are moving in a similar way as they did in previous years.

Let´s check it with a easy example. The chart below is Live Cattle spread LE GJ5 (Live Cattle February-April 2015), the blue line represents the current spread with maturities of 2015. The black line is a calculation of seasonal spread (Feb-April) in previous years. The gray lines are standard deviations from the seasonal line.

Before the red arrow, the spread was following its seasonality in a precise way. But something happened in that moment for the relationship between these two future contracts to get out the line of historical behavior.

You can continue trading on the spread (in fact, it has been in my portfolio recently: Spread Live Cattle GJ5), but being aware that this year the reference of previous years does not count.

2- Choose a spread that is not too close in time. It is interesting to have enough time to recover. Only if there is not a "black swan". In that case, we would run the stop loss.

As usually, we will check it better with a graph. In this case, we will focus on energy futures: spread heating oil - gasoline. We have a bearish seasonality in the two charts shown. But, what spread has more recovery time, if the spread separates from seasonality? In January´s spread (missing 1 month) or August´s spread?

Another reason to be cautious with a spread, when approaching the first maturity, are sudden movements they usually do.

3- Spreads formed with contiguous maturity futures are logically more stable than those that are further apart in time. These spreads are called calendars and are the most common.

4- Evaluate the behavior of the current spread in relation to seasonality. Although I analyze longer periods, the temporary space that I have more in mind is that of the last six years.

And why is that?

I start may seasonal analysis in 2008 because it was the year of the financial earthquake. It marked a line in the sand in the behavior of the various assets. For that reason, I have much more into account the period after 2008.

When we calculate the seasonality with too many years, the seasonal line flattens and standard deviations away. It becomes a little usable information.

If we focus on meat futures, first we must study the months with maturities. Let me show again the picture I posted in the previous article:

There are two months of the year in which we have maturities of Lean Hogs and there are not Live Cattle maturities. These months are May and July. Be especially careful with Lean Hogs´ May maturity, because it has very little volume. If we include this contract into a spread or a butterfly, it will cause strange behavior. The following table shows today´s data on Lean Hogs futures. May´s contract volume is ridiculous.

Another aspect to consider when we discuss spreads, is the volume of each of them. In the following table, you can check spreads (SP) and butterflies (BF) available for Feeder Cattle. Let's focus on spreads (two legs).

Each rectangle has in common the first leg: GF F5 (blue), GF H5 (red), GF J5 (black) .... and so on. Within each box, the first spread has the highest volume, because it has the closest maturity.

I pointed out the spreads that I find most interesting. I discard the maturity of January because there is only one month left. And I keep HJ5 GF GF GF JK5 and KQ5. The rest, which are formed by separate maturities, are highly illiquid.

Finally, I propose a simple exercise. In the next chart, you can check Live Cattle spreads and Butterflies. Can you identify the best spreads to operate? I noted with red boxes the spreads between Live Cattle and Lean Hogs to ignore them.

Click this link to read the first article on meat futures: Meat Futures Spreads (introduction)

I have prepared seasonal charts with: Scarr Visual Trading

Please, feel free to ask anything you need!

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