Whether you are a rancher in the beef or pork industry or a seasoned speculator, the livestock futures contracts traded at the CME provide market participants with a liquid and transparent way to manage risk or speculate on price movement. In this article, we'll show you how to choose one of these meaty markets for your portfolio.
Note: It is important to understand that trading in this type of market involves substantial risks and is not suitable for everyone; even when it is suitable, only risk capital should be used. Any investor could potentially lose more than expected. (For more insight, read Futures Fundamentals.)
What are Livestock Futures Contracts?
A livestock futures contract is a legally binding agreement for delivery of livestock (or cash equivalent) in the future at an agreed upon price. The contracts are standardized by a futures exchange as to quantity, quality, time and place of delivery. Only the price is variable.
The meats have long been considered one of the more volatile markets because they have been known to lock-limit up and down in the same day. This usually happens on days where a United States Department of Agriculture (USDA) report is released. This is not to say that the meats don't trend, but on any given day the markets can be extremely wild.
Hedgers and Speculators
The primary function of any futures market is to provide a centralized marketplace for those who have an interest in buying/selling physical commodities at some time in the future. The meat futures market helps hedgers reduce risk associated with adverse price movements in the cash market. Examples of hedgers would be food processors, ranchers and the food service industry. (To read the basics of commodity markets, see Commodities: The Portfolio Hedge, Commodity Prices And Currency Movements and Who sets the price of commodities?)
Hedgers take a position in the market opposite of their physical position. Due to the price correlation between futures and the spot market, a gain in one market can offset the losses in the other.
|For example, a rancher who is looking to sell his cattle some time in the future is worried prices will drop, and that he will get a lower price for cattle. To hedge his risk, the rancher will sell futures that will make money if the price of cattle drops. If the market moves up, he will lose his money on the futures position but will make money on the sale of his cattle.|
The Major Meats
There are four different markets that trade livestock at the Chicago Mercantile Exchange (CME). They are: live cattle, feeder cattle, pork bellies and lean hogs.
1. Live Cattle
According to the CME, the live cattle contract reflects current supply and demand for competing meats and feed grains, along with long-term cyclical patterns for meat supply and consumer preferences. Interestingly enough, the live cattle futures contract was the first contract to be based on an underlying commodity that was alive.
Live cattle are traded in dollars and cents per pound and one contract controls 40,000 pounds; therefore, if the current price is $0.90 per pound, the total value of the contract is $36,000.
| For example, if a trader is long one contract of live cattle at $0.9260 per pound and sells at $0.9500 per pound, that trader will make a profit of $960 ($0.95 - $0.926 = 0.024, 0.024 x 40,000 = $960).
On the other hand, if the trader sells at $0.90, he or she will lose $1,040 ($0.926 - $0.90 = 0.026, 0.026 x 40,000 = $1,040).
The minimum price movement or tick is $0.00025 or $10 per contract. The exchange also has a limit that is the allowable daily move in a market. For live cattle, the daily limit is $0.03 or $1,200 per contract. The exchange sets position limits to maintain an orderly market and to make sure no one market participant has too many positions at any one time. There are different limits for speculators and hedgers.
The most active months traded (according to volume and open interest) are February, April, June, August, October and December. Live cattle are delivered in numerous places around the U.S. in Syracuse, Kan;Tulia, Texas;Columbus, Neb.;Dodge City, Kan. and Amarillo, Texas.
2. Pork Bellies
According to the CME, frozen pork belly futures are essentially bacon in storage. Pork bellies were the first futures contract offered at the CME where the underlying commodity was a form of frozen meat.
Frozen pork belly contracts are traded in cents per pound and one contract is for 40,000 pounds of cut and trimmed pork belly. Much like live cattle, each penny move equals a change in $400 for each contract.
The tick size is $0.0025, or $10 per contract. The CME's daily limit for pork bellies is expandable, but starts off at $0.03.
The most active months for delivery (according to volume and open interests) are February, March, May, July and August.
Pork belly contracts, like live cattle, also have position limits set by the exchanges.
According to the CME rulebook, delivery for pork bellies are at CME-approved warehouses east of the western boundaries of North Dakota, South Dakota, Nebraska, Kansas, Oklahoma and Texas.
3. Feeder Cattle
Feeder cattle represent living cattle to be placed in the yard for fattening. Feeder cattle are a derivative of live cattle.
The feeder cattle contracts are very similar to the live cattle contracts; the only difference is the size of the contracts. Whereas the contract size for live cattle is 40,000 pounds, feeder cattle contracts sell for 50,000 pounds.
|For example, if a trader was long from 105.50 and sold at 106.50, that trader would make $500 (106.50 – 105.50 = $0.01, $0.01 x 50,000 = $500).|
The minimum tick is still $0.0025, but in feeder cattle that equals $12.50 per tick. The daily limit is $0.03, or $1,500 per contract.
Feeder cattle are traded in January, March, April, May, August, September, October and November.
Unlike some of the other meat-related futures contracts, feeder cattle contracts are settled with cash, so ultimately there is no delivery.
4. Lean Hogs
Lean hogs trade much like live cattle and pork bellies in that one contract equals 40,000 pounds and it is traded in cents per pound. Therefore, every penny move in hogs equals a $400 change in each contract. For example, if the market moves from $0.58 to $0.60, this represents a move of $800 per contract.
The minimum price move, $0.00025, is the same as that of the other "meats". Lean hogs are traded in February, April, May, June, July, August and October. Position limits also apply.
Similar to feeder cattle, lean hogs are also cash settled, which means there is no delivery.
The Bottom Line
The meats offer investors a lot of opportunity because they tend tend to feed off of grain prices and (lately) mad cow disease. Also be aware that these markets are still pit traded, which has its own inherent pitfalls. Any investor looking to profit from the meats needs to be aware of the risks of investing in such a volatile market.