Trading the 2015 Cattle Market

Andy Waldock |

The live cattle market was up 28% in 2014 and the Feeder cattle market was up 32% for the year. The cattle markets made all-time highs in 2014 as the U.S. had its smallest slaughter in 20 years. This came as no surprise as we've discussed the declining trend in the domestic herd several times. Based on the cheap feed prices, cheap fuel costs and a strong Dollar, this should be another year of declining supply as the U.S. begins to grow its herd to meet the growing foreign demand.

Cheap feed costs and improving pastures allow ranchers to hold back their animals at affordable prices. The commodity price spike due to the drought of 2008 forced many ranchers to cull their herds and exacerbated the free fall in the U.S. herd numbers. Finally, the margins have turned in the ranchers' favor and we expect to see this continue through 2015 on the farms and at the feedlots. More important than our speculation on future prices are the actions the commercial traders take in the futures market. We track their behavior through the CFTC's weekly Commitment of Traders Report. This is the basis for the majority of our trading.

The discretionary version shown below plots the futures price in the first graph and our analysis in the bottom three. It's a very simple three step process that uses the same measurement tools, rules and inputs across all domestically traded, liquid markets. First, we only trade in the direction of the commercial traders' momentum. Our research shows that they're the ones with the access to the best models of their markets. Their collective actions are plotted in the third pane of the chart as the net commercial position while their momentum is plotted in the bottom pane.

Secondly, we wait for our short-term market momentum  to get compressed against the commercial traders' momentum. This allows us to minimize the risk of the trade. Commercial traders are less affected by short-term market movement. The downside of this approach is that we miss the runaway winners. The upside is that it cuts down on the total number of trades as well as reducing risk on a trade by trade basis.

Positive commercial trader momentum combined with a short-term oversold market equals a buy setup ready to trigger.

Negative commercial momentum combined with a market that is overbought in the short-term creates a short selling opportunity setup.

Finally, the third step is the trigger. We require the market to move a given amount in our intended direction before entering the market ourselves. This adheres to the old adage, "Never catch a falling knife." The reversal cues our entry. The highest or, lowest point of the preceding couple of days becomes the swing high or, low. We'll use that point for protective stop placement.

The past year's discretionary COT Signals in feeder cattle futures are shown accordingly on the chart below.

Discretionary version of COT Signals in Feeder Cattle for 2014.

We've also synthesized this process into a fully mechanical trading program. We break the mechanical programs up by long and short and whether they're following the commercial traders or fading speculative activity. The chart below shows the short selling program following the commercial traders.

Short selling version of our mechanical Commitment of Traders program in Feeder Cattle futures.

Obviously, the mechanical version picked up several trades not caught by the discretionary version. This should have been a complete wipe out for a program that is designed to trade the short side of a market that was up 32% for the year. Fortunately, tight risk controls have kept the losses to a relative minimum and the program is still just shy of its equity highs.

Equity curve for commercial short feeder cattle trading program.

Build your own Mechanical Portfolio.

We're pretty happy with this performance because when we combine it with the long side of our commercial live cattle trading program, we get the results below.

Our philosophy of following the commercial traders has served us well as a proxy for fundamental market information. These are the people and companies who base their livelihoods on following a single market. Their physical usage and production leads them to underlying value time and time again. Therefore, we'll continue to track their actions in the cattle markets through 2015 and beyond.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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