Lean Hog Seasonal Spread Jan11


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Lean Hog Seasonal Spread

One of my favorite styles of trading the Futures markets is the Intra-Commodity Spread. For this trade, we are going to be simultaneously buying and selling contracts of the same Commodity in different months. Once we have established this position, we will monitor the net difference between the two contract months. This is known as the Spread. We will be looking at the June11/February11 Lean Hog Seasonal Spread.

Lean Hog June 2011 (HEM11) Last Price = 89.10
Lean Hog February 2011 (HEG11) Last Price = 76.00
Spread (difference between June/February price) = 13.10

Lean Hog Seasonal Spread

The Spread always posts the buy side first and the sell side second. When we post the buy side first then the sell side, we will be making a profit on our trade when the value of the Spread becomes more positive. We will be buying the June 2011 contract while simultaneously selling the February 2011 contract. This type of Spread is also known as a bear Spread because we are buying the deferred contract and selling the nearby.

You are probably wondering why I chose this particular Spread out of all the choices I could have had. I use a service by Moore Research Company (www.mrci.com) to identify when these Seasonal patterns are ready to be traded. If you are interested in a free trial to these reports, MRCI has agreed to give all readers of Lessons from the Pros a complimentary two weeks of the service. Contact Melissa Moore at melissa@mrci.com or (800) 927-7259.

Once I am alerted to these Seasonal patterns, I then begin my analysis to time my entry and check the fundamentals of the Lean Hog market to see if there is an event that may cause the Seasonal pattern to fail this year. This particular Spread has closed higher on January 11th than on December 2nd for the last 15 out of 15 years. The average profit over 15 years has been $821. While there have been no losing years, there have been some draw downs (losses before off-setting the position). This is why we look at our charts and determine the trend and supply/demand levels that we can use to obtain a more ideal entry price to help eliminate some of these draw downs.

Spread traders profit by the Spread becoming wider in price. In this case, the current Spread value is 13.10. If the Spread trades to 15.32 (more positive), we are profitable. If the Spread trades to 12.37 (more negative), we are losing money.
In the Fall season, farmers use the abundance of harvested Corn to fatten the Hogs in preparation for the annual slaughter season. Once this slaughter season peaks and begins to decline into the early Spring, the market awards progressively greater premiums (higher prices) to those Hogs deliverable when supply is lesser. This is why we are buying the June contract and selling the February.

Looking at the prices of the Lean Hog contract (http://www.mrci.com/ohlc/ohlc-03.php), all the deferred months are all showing higher prices. This shows we are in Contango (normal market, nearby prices are lower than deferred) with no supply shortage. Since we are placing a bear Spread, this is good information for our position.

Figure 1 shows us the Lean Hog Spread with a line on close chart (black line). We will also see the historical 15-year Seasonal pattern of this Spread (blue line). The vertical yellow area is our Seasonal window from December 2nd to January 11th.

Figure 1

Figure 1

When looking to enter Spread positions on an optimal entry date (December 2nd), we are rarely at a demand (support) area for an entry. For this I like to create a window of two weeks before the optimal entry date and two weeks after. This allows the market time to come to trade back to a more desirable demand (support) zone.

Figure 2 will show us some of the technical levels of the Spread.

Figure 2

Figure 2

The Spread had been in a long basing pattern for several months before breaking out in early October. After a strong rally, the Spread has corrected back to a nice demand (support) level (B). Notice that our moving average (50 sma) is pointing up as the Spread trades down to our level showing us the uptrend is still intact. I like to see the price come back close to or touch our moving average. The moving average is not a support level, but the pullback tells me that the market has been correcting and possibly ready to resume the impulse wave up. The Spread reached our demand zone during the optimal time window of +/- 2 weeks of the optimal entry date of December 2nd. By drawing a diagonal trendline (A) from the November highs, we can see that our Spread is moving favorably in our direction for now.

Entering the trade at (B 12.00) would allow me to have a 1.00 ($400 risk) stop on a closing basis under my entry. Remember that Spread trading does not allow for stops to be placed in the market. We must use mental stops and have the discipline to exit if the market trades there. This would clearly break my demand level and prove me wrong. The weekly Spread chart (not shown) shows a supply level (resistance) at 15.50 which will be a good place to look for profits, otherwise, we just hold the Spread until the Seasonal window closes on January 11th.

You may notice there is a possible Head & Shoulders pattern forming on the Spread. I will monitor this and if the market breaks the neckline decisively on a closing basis, I will exit the trade.

Please keep in mind that this example is for educational purposes only and is not a trade recommendation. By posting this trade, I am sharing my thought process of trading an Intra-Commodity Spread with you.

The amount of cash I would have to post for margin to trade an outright Lean Hog Futures contract would have been $1,485. These Spreads will only cost $608. The Futures exchanges recognize these Spreads to be a form of a hedge trade and give Spread traders a considerable discount.
Spread trading is not perfect; no form of speculation is. However, I find that trading Spreads with these Seasonal patterns allows for some very good risk/reward trades.

Good trading,
– Don Dawson