Expect a Near-Term Top in the Live Cattle Market

Name: Dennis Smith Company: Archer Financial Services

Years Trading: 21

Expect a Near-Term Top in the Live Cattle Market
By Dennis Smith, Archer Financial Services

The cash steer market has been fully steady to higher for ten consecutive weeks. The Feb contract has rallied from the January low of 8500 to the recent high of 9300. The number one bullish fundamental appears to be the harsh winter conditions in the Great Plains. Cattle in the feed lots have been severely stressed, much more so than in most winters. This results in cattle marketings being delayed and when they are moved to slaughter the average weights are down from normal levels. The feed conversion of a stressed animal becomes so poor that feedlot managers just move the animal to slaughter. Indeed, average dressed steer weights have been running from 18 lbs to as much as 25 lbs below year ago weights. Over time, this amounts of a lot of tonnage lost. The other contributing factor to the recent strong rally has been impressively strong beef exports. Recent data confirmed that beef exports during December were 25% above year ago levels. Finally, the harsh winter conditions have prevented cattle from being placed into the feed lots, keeping total cattle-on-feed inventories at tighter levels than expected.

What is Likely to Happen Next?

The fact that cattle supplies are tight and average cattle weights are down from last year has been the bullish driving force sending cash steer prices to the recent high of 92 to 92.5 cents/lb. I indicated that export demand appears to be strong as well. What about domestic demand?

I'd say that domestic beef demand, or lack of demand represents the "Achilles Heel" of the cattle complex. I'm concerned that persistently high unemployment and poor consumer confidence will keep domestic beef consumption from enjoying the normal seasonal push into the spring grilling season. Also, the series of harsh winter storms along the Eastern Seaboard is not good for meat consumption. A higher percentage of beef is consumed outside of the home than is pork and poultry. Harsh weather along the densely populated east coast forces more consumption at home and less in restaurants. This is more detrimental to beef consumption than pork or poultry. Finally, from a seasonal standpoint, in most years the live cattle futures market will forge a top in late February and tend to work lower during the next thirty to forty days. I'm expecting a seasonal top to develop this year. Technically, it appears that cattle futures are overbought and the trend following funds, which have been long the market, appear to be exiting their length.

So How Does One Attempt to Profit from a Seasonal Top in Cattle Futures?

First off, I'll address the long term picture before outlining short term trading strategies. Live cattle futures, prior to the recent rally, had been trading in a sideways range for over a year. The fact that they have broke out to the upside should not be taken lightly. In other words, while I'm expecting a seasonal top, I consider the possibility that the December lows represent long term lows in the live cattle market. Thus, I want to approach the idea of a seasonal top with caution. The best way to do this is by utilizing option strategies designed to profit in a lower market, but not lead to large losses in the event, there is no seasonal top or in the event the seasonal pullback is very shallow. Listed below are my trade ideas/suggestions with the first being the most conservative and the last being the most aggressive. I will be recommending these strategies to my clients for both speculative trading and hedging trading positions. Feel free to call me with questions or information on opening a trading/hedging account.

• Purchase the April live cattle 92 puts at 170 points or less. This represents a premium outlay of $680 per option. April live cattle options expire 35 days from today on April 1.


• Establish the April live cattle 93/88 put spread at a net premium outlay of 180 points. This is my favorite strategy. While the premium outlay is greater than purchasing the 92 put, currently the 93 put is 100 points in-the-money. Thus, with 100 points of intrinsic value, the net cost of this position, (80 points) is less than buying the 92 put. Most of my hedge clients utilize put spread strategies. The beauty of the first two strategies is you'll profit if cattle futures stage a seasonal break yet the risk is totally limited to the net premium paid.


• Establish a risk reversal in April live cattle options. This strategy would involve purchasing the April cattle 93 puts, selling the 88 puts and selling the 95 calls at a net premium outlay of 120 points ($480). This strategy will work well in event of a seasonal break, but also adds risk to the position by being short the call option. This position, unlike the previous two, requires margin capital. The margin required will increase if the market moves higher and decrease if the market moves lower. Many of my hedge clients will utilize this strategy as well.


• Sell April live cattle futures at 9220 and use a protective buy stop at 9370 stop. This represents the most aggressive approach but runs the risk of being stopped out only to see the market then top out and break severely. The current speculative margin to trade cattle futures is $1,080 per contract. This trade idea represents an approximate risk of $600.

If I'm correct regarding a seasonal top in live cattle futures from current levels, a possible downside target would be in the 8930 to 8825 range.

If you would like a free 30-day trial to my evening livestock wire give me a call or send me an email to dennis.smith@archerfinancials.com or 1.877.377.7905. This daily wire contains a fundamental discussion of the livestock markets including a brief section on the grain market.

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