Bears Love Pork

Sep.21.10 | About: iPath DJ-UBS (COW)

By Brad Zigler

Yeah, yeah, I know... Yesterday's screed, "When Pigs Fly, They Also Fall, dealt with the über-exciting market for lean hogs.

You come to a website named "Hard Assets Investor" for the express purpose of learning about swine, right? Well, you do if you're looking for inexpensive entree to the commodity markets.

Yesterday, I argued that the odds favor a short in the hog market.

Investors who rely upon unmargined exchange-traded security products for their commodity exposure don't have a lot of options to capitalize upon this opportunity, however. But, if they can stretch their definition of a "low-risk trade," the reward-to-risk characteristics of a "bear spread" could very well justify a trip across the line into a futures trade.

A bear spread entails selling a nearby futures contract and simultaneously buying a contract with a distant delivery date. For the hog market now, that might mean buying a February 2011 futures against the sale of a December 2010 contract. The trade's known as a bear spread because a bear market would tend to widen the price spread between the two deliveries.

Presently, December hogs trade for 77.80 cents a pound, while the February contract is changing hands at 81.125 cents. That puts the spread at 3.325 cents. As a bear spreader, you'd want the price differential to get bigger. That seems imminently possible over the next couple of months.

There are several ways that the spread could widen. That's the beauty of spread trading: Unlike taking outright futures positions that profit only when the contract price appreciates (if you're long) or depreciates (if you're short), spreads can profit as a number of scenarios arise, namely:

  • When the long leg rises and the short leg falls;
  • When the long leg rises and the short leg remains unchanged;
  • When the long leg rises and short leg rises at a slower pace;
  • When the short leg falls faster than the long leg, and
  • When the long leg remains unchanged and the short leg falls.

Clearly, bear spreads — indeed, spread trades in general — are not precision trades. They're very forgiving to the novice trader.

Still, you have to ask yourself, why bother with it all? One compelling reason is cost. Margin requirements for spreads are lower — a lot lower — than outright performance bonds.

If you sell December futures outright today, the exchange clearinghouse will demand a minimum margin deposit of $1,283 per contract (a brokerage firm, however, can require higher deposits). A spread can be done with a deposit of only $608 (again, brokerage firm levels can be higher).

The lower margin requirement leverages the profit and loss potential of the spread. A 10-cent-a-pound drop in the price of a short hog contract held outright translates to a 312 percent return on margin (a lean hog contact calls for delivery of 40,000 lbs.). A similar widening in a bear spread would translate to a 658 percent return.

So, here's a little food for thought: Bears may want to cook up a little pork spread for the weeks ahead.

Disclosure: No positions