Lean Hog Options are Expensive going into “The Deal”

The seasonal low in lean hog futures is due in the coming weeks and with the U.S.-China trade deal set to be signed this week, we could start seeing Chinese demand for U.S. pork normalize. Even if it doesn't, the U.S. market has probably priced in a near worst-case demand scenario. Thus, we like playing the upside in a well-hedged manner using diagonal put spreads.

Specifically, selling the April lean hog 66.00 put and buying the February 60.00 put creates a strategy that stands to profit whether hogs trade higher, lower or sideways; but will lose it prices decline dramatically (see chart below). The spread can be sold for roughly $700 before considering transaction costs and comes with a margin requirement of just $495.

The risk and reward calculations are complicated by the fact that this trade involves options with two expiration dates. The short April 66.00 put expires in about 60 days while the protective long February 60.00 put expires in about 30 days. If both options were held to expiration, the max profit would be in the ballpark of $700, but that would require holding a naked short put for 60 days beyond the expiration of the February options. This isn't something we would recommend. But if the trade is still viable after the protection expires, and additional hedge could be executed.

However, if everything goes as planned, we suspect we can buy the spread back in the coming weeks at a much lower price than the spread is being sold for today. Our initial profit target for the spread will be $400. On the flip side, due to the difference in futures pricing, the intrinsic risk on this spread is less than the 6.00 points between strike prices. In fact, because the April future is about 8¢ higher than February, there really isn't any intrinsic risk but we estimate that if things go wrong the risk could climb into the several hundred to $1,000 range.

Carley Garner is the Senior Strategist for DeCarley Trading, a division of Zaner. She authors widely distributed e-newsletters; for your free subscription visit www.DeCarleyTrading.com. She has written four books, the latest is titled “Higher Probability Commodity Trading.”