Executive summary

Weather impacts have seemingly led to high prices and record open interest and volume in the feeder cattle futures and options market. In this report, Rich Excell looks at market fundamentals to identify potential impacts, then uses technicals to identify specific setups that could be implemented via options.

Image 1: U.S. drought conditions as of September 12, 2023

Hot, dry weather across the Great Plains has led to drought conditions in many of the states that produce the most feeder cattle. As you can see from the map above, most of Texas as well as Oklahoma, Kansas, Missouri, and Nebraska -- half of the top 10 states for feeder cattle -- are suffering from drought conditions. This has led to meaningful uncertainty when considering herd expansion.

Image 2: Is an El Niño about to hit the U.S.?

However, according to forecasters at the NOAA, an El Niño is still expected to hit the U.S., with a 95% chance it hits in January through March. In fact, the NOAA says that while the El Niño has been expected since April, its influence on the U.S. is weak over the summer but more pronounced starting in late fall and through the spring. Thus, prices could stay higher through the October time frame, which is a critical period as supplies will remain tight at the same time they are expected to peak seasonally. 

"Depending on its strength, El Niño can cause a range of impacts, such as increasing the risk of heavy rainfall and droughts in certain locations around the world," said Michelle L'Heureux, climate scientist at the Climate Prediction Center. "Climate change can exacerbate or mitigate certain impacts related to El Niño. For example, El Niño could lead to new records for temperatures, particularly in areas that already experience above-average temperatures during El Niño.” 

El Niño’s influence on the U.S. is weak during the summer and more pronounced starting in the late fall through spring. By winter, there is an 84% chance of greater than a moderate strength El Niño, and a 56% chance of a strong El Niño developing. Typically, moderate to strong El Niño conditions during the fall and winter result in wetter than average conditions from southern California to along the Gulf Coast, and drier than average conditions in the Pacific Northwest and Ohio Valley. El Niño winters also bring better chances for warmer than average temperatures across the northern tier of the country.”

In the August 1 USDA cattle on feed report, placements of feeder cattle were down 8% and at the lowest level since 2017. 

However, if the El Niño produces the cooler and wetter weather across the Southern US that is expected, what impact would this have on Feeder Cattle futures prices that are so high because of the persistent drought conditions in critical feeder cattle states?

Image 3: Feeder Cattle options volume and open interest

With so much uncertainty in the market, and prices continuing to rise, the interest in hedging via the Feeder Cattle options market has never been higher. I can see that the open interest for both puts and calls has risen steadily throughout the year and has recently gotten to all-time highs. I can also see that the put/call ratio is above 2, suggesting that traders are looking to hedge against a sudden fall from the 40%+ rise in futures prices this year.

Image 4: Generic front month Feeder Cattle future on both the daily and weekly Ichimoku chart

As you I can see from both charts, the price action in Feeder Cattle has been very strong this year. On the top chart, I can see in the daily chart that the trend higher still remains strong, the MACD in the middle panel points to higher prices, and the RSI in the bottom panel is yet to get to overbought levels. 

However, that is not the case on the weekly charts. These charts also indicate the same explosive price move higher. However, I can see on the weekly MACD, we are crossing lower and indicating that we might be at the point where a counter-trend move is developing. Interestingly, the weekly RSI remains in the most overbought area in the past five years. 

So, while prices could still continue higher in the near term, one might think that they could be set for a counter-trend move lower over the coming weeks or months. 

Image 5: Live Cattle vs. Feeder Cattle futures prices

Feeder Cattle have over a 90% correlation to Live Cattle prices. If I look at the relative price of the generic front month futures of each contract, I can see that the Live Cattle prices are at the lowest relative levels vis a vis Feeder Cattle that we have seen in the last five years. In fact, every other time we have seen the relative price hit this level, we have seen a correction in the spread. It is a very mean-reverting relative relationship.

Image 6: Historical spread between Feeder Cattle November 2023 futures and January 2024 futures

This same relative extreme exists within the Feeder Cattle complex itself. Looking at the futures curve, I can see than the November 2023 contract is over two standard deviations low relative to the January 2024 contract. In fact, the only time this contract has been at a relative discount, and it was small, was back in February very briefly. This may suggest that the relative futures spread may narrow soon.

Image 7: Feeder cattle implied volatility term structure

Turning to QuikStrike, I want to get a gauge on how the relative implied volatility pricing looks across the term structure. From this, I can begin to gauge where there is concern and where there is more muted expected volatility. I can also get a sense of where the bulk of the hedging activity has occurred because traders looking to hedge will drive the cost of insurance, and therefore implied volatility, higher on a relative basis. 

October and November look particularly low relative to all months around it. In many ways, I find this surprising given that October and November are key months for the calving season, calving supplies, and the outlook for feeder cattle going forward. 

Image 8: Implied volatility surface for Feeder Cattle options

I also want to get a sense for the relative pricing of puts and calls and how this has taken shape in the different expirations. In the light blue column in the center, we can see the same implied volatility from the term structure graph. The additional information on this graph is the calls and puts in each expiration relative to not only the at-the-money of the same expiration, but also relative to the calls and puts of different expirations. From here I can see that the 25 delta puts relative to the at-the-money and relative to the 25 delta calls at each expiration look relatively inflated. I can also see that the 25 delta calls trade below the at-the-money and this difference tends to be wider the further you go out.

Image 9: Expected return for long 1 January 2024 265 puts and short 1 November 255 puts

Pulling this all together, I am looking to fade the recent move higher in futures. It has been driven by extreme hot and dry weather leading to drought conditions in key states. However, the El Niño weather looks set to happen in late Fall and through the winter, which may reduce these effects and potentially bring futures prices lower. These prices are technically overbought and the weekly MACD is turning lower. 

If I look at the Feeder Cattle futures, they are expensive relative to their own history and relative to other products such as Live Cattle. Within the Feeder Cattle futures curve, January looks relatively expensive vis a vis October or November and so this is where I want to focus my short position. Given the risk of a blow-off top move in future, I would rather use options to express my view. However, January at-the-money options look expensive relative to October and November at-the-money. I would like to defray some of the options premium risk, but since January looks expensive, I instead look to sell puts in November as the 25 delta puts are high relative to the at-the-money. Thus, the implied volatility spread on the options I buy vs. the options I sell are not that different. 

The risk is that futures collapse in the near term, and we move below the 255 strike I have sold for November expiration. Given the pricing of November futures vs. January, if this were to happen, it is reasonable to believe that January futures could fall just as much if not more. In this case, my 264 put options in January do more than compensate my risk of loss. The biggest risk is a continuation of prices higher all the way through January expiration. Given the very overbought RSI for all expirations, this is a risk I feel it is worth taking. 

In the best case, futures move lower slowly in the near term, with uncertainty keeping a big to implied volatility. My 255 November puts expire worthless, and I am left with January 264 puts at a much lower cost than I would otherwise have to pay. 

Playing for countertrend moves can be difficult and expensive. Options implementation can help with this, but traders are right to be hesitant at times to spend the premium. Trying to find the pay place on the volatility surface to sell some options and help defray the cost of implementation is the trader’s best strategy in my opinion.

 These are interesting times in the Feeder Cattle market. Interesting times call for interesting ideas. Good luck trading.

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