Trading Opportunitities in Lean Hogs

Market participants have the ability to simulate the financial results of a hog feeding operation by using hedging and trading strategies that incorporate various combinations of CME Group Agricultural futures contracts. This simulation of a real world product transformation (the conversion of one product into multiple products or taking multiple products and converting them into one product), is frequently called a “crush” trade. The “crush” term originated in the soybean processing industry where commercial participants buy soybeans and crush them, and then sell the resulting soymeal and soyoil. In the soybean crush, a raw material input (soybeans) is processed and transformed into output products (soybean meal and oil).

A similar process exists in hog feeding, though it differs in that multiple inputs are transformed into a single output. Specifically, hog finishing operations buy feeder pigs and feed them until they reach market weight—until they are ready for slaughter. This process is commonly known as the gross feeding margin (GFM) or the “hog feeding spread” and provides a profitability estimate of the swine finishing operation. Since there can be volatility in the GFM, hog producers should consider managing their price risk by trading the hog feeding spread (a.k.a. Hog Crush spread) in the futures market.

The Hog Crush in the futures market involves buying (going long) Soybean Meal and Corn futures and selling (going short) Lean Hog futures.

Certain market participants seek trading opportunities based on price or spread movement. As there can be significant volatility in the Hog Crush, there may be opportunities for them in this strategy. The involvement of these spread traders provides market liquidity, which in turn benefits those in the hog feeding business who want to get in and out of their market positions at a fair and efficient price level or spread.

Hog Feeding Operations – the Mathematics

The majority of hogs are now shipped as young, feeder pigs (averaging 40 pounds but ranging from 10 to 60 pounds)to finishing facilities that grow the animals to 260-290 pounds for slaughter. This corresponds to a carcass weight between 190 and 211 lbs. (205 lbs., on average) as a market hog’s dressing percentage (the ratio of live weight to carcass weight) is approximately 73%. Estimating the carcass weight is important because most cash market contracts and the CME Lean Hog futures contract are based on carcass weight.

This process takes place over four to five months and each animal consumes between 600 to 1,000 pounds of feed during that time period. It should be understood that the time period for feeding and the rate of gain can vary due to factors such as market forces, weather conditions, disease outbreaks, and seasonal trends.

Although other expenses such as operating overhead, death losses, transportation, additional feed ration ingredients, medications, and veterinarian bills are not are not included in the hog feeding spread or Hog Crush examples in this document, they definitely will impact the profitability of a hog feeding operation. The relationship of the local cash markets for hogs and feed to the futures markets (the basis) is also needed to calculate what the final GFM value will be for a particular location.

The Gross Feeding Margin

The difference between the purchased inputs value and the sold finished hog value is known as the gross feeding margin (GFM). The GFM represents the returns per hundred-weight of lean hogs (on a carcass weight basis) above the costs of feeder pigs, corn, and soybean meal. One common formula for calculating the GFM at marketing is:

GFM t= 2.05 * LH t - WP t-5-(10 * C t-5)-(0.075 * SM t-5)

Where GFM t is the gross feeding margin in marketing month t, LH t is the lean hog price (in $/cwt.) at the month of marketing times a 200 pound (2 cwt.) carcass, WP t-5 is the price of a weaned feeder pig at placement, C t-5 is the corn price at placement times 10 bushels, and SM t-5 is the soybean meal price at placement times 0.075 tons. Producers can adjust this formula as needed to more precisely estimate the GFM for their particular operation. For example, the coefficients in front of the price variables can be adjusted to reflect a specific producer’s anticipated feed inputs or different market hog weights.

Furthermore, the expected basis for a particular location is commonly added to the current futures price for a given commodity to generate expected cash market prices. These expected cash market prices are then used in the GFM model to predict the actual cash price which a hog producer will face when purchasing feed and selling hogs.

As shown in Figure 1, there is a high degree of movement in the gross feeding margin, which motivates hog finishers to seek ways to hedge the financial aspects of their operations. The futures Hog Crush trade can provide a vehicle for managing these risks.

The Hog Crush Trade

The “Hog Crush” is a spread trade executed in the futures market where the ratio of contracts traded closely mimics the economics of the swine GFM. A Hog Crush trade that represents the hog feeding process consists of selling (going short) Lean Hog futures and purchasing (going long) Corn and Soybean Meal futures. Before determining how many contracts of each commodity to trade, traders should first understand the basic relationships between feed and weight gain in hog operations.

A common ratio for the feed mix is four parts corn to one part soymeal and three pounds of this feed ration is needed to produce one pound of live-weight gain in a hog. On a carcass weight basis, the feed-to-gain ratio is closer to 4:1 because most hog carcasses are 73.5% of the animal’s live weight. As noted earlier, most feeder pigs are placed on the finishing ration at approximately 40 pounds. To reach a finished, live weight of 280 pounds (gaining 240 pounds) each pig will eat approximately 720 pounds of feed (240 pounds of gain times a feed-to-live- weight-gain ratio of 3:1).

Knowledge of these relationships is useful in determining the number of contracts to trade in the Hog Crush. Let’s look at an example of a hog producer who plans to feed 1,500 pigs to a finished weight of 280 pounds each from an initial weight of 40 pounds. The total live weight of production is 420,000 pounds (4,200 hundredweight cwt.). The final carcass weight for market is 308,700 pounds. The total amount of feed to raise the pigs to the final live weight is 1,080,000 pounds of feed, which will consist of 14,464 bushels of corn and 94 short tons of soybean meal.

As such, the hog producer will need to sell eight CME Lean Hog futures contracts to hedge the expected carcass weight, and purchase three Corn futures contracts and one Soybean Meal futures contract to manage the risk of the Hog Crush.

To feed these 1,500 hogs, the hog feeder will need approximately 1,080,000 pounds of total feed (1,500 pigs times 720 pounds). Most hog finishing rations contain between 70% to 85% corn and 8% to 23% soybean meal. Assuming a feed ration of 75% corn and 18% soybean meal, the hog feeder would need 810,000 pounds of corn (14,464 bushels) and 194,400 pounds (97.2 short tons) of soybean meal.

Using the above ratios, three contracts of Corn (15,000 bushels or 840,000 pounds) coupled with one contract of Soybean Meal (100 short tons or 200,000 pounds) will hedge or replicate the purchase of 1.08 million pounds of feed. Using this 8-3-1 Lean Hog-Corn-Soybean Meal contract spread, the hog producer will over-hedge the expected output of carcass weight hogs by 3.7% or (11,300 pounds or approximately 52 hogs). Similarly, the corn and soybean inputs will be over-hedged by 3.7% and 2.8% respectively (see Table A1 in the Appendix for calculations). Alternatively, hedging with a 7-3-1 spread would underhedge the price risk of these 1,500 hogs by 9.3% (see Table A2 in the Appendix). This may serve to counteract the overhedging of Corn and Soybean Meal and provide a more balanced risk profile for the hog producer.

It is important to know these percentages to understand the amount of additional risk a hedger or speculator is taking by hedging or spreading using these ratios. Adjusting the number of contacts bought or sold in the Hog Crush will adjust the amount of residual risk from over- or under-hedging.

For speculators, adjusting the number of contracts is the only way to change the risk profile of the spread strategy. Trading a 20-7-2 spread trade would replicate placing 3,880 hogs on feed (20 contracts times an approximate 194 animals per contract), which would require approximately 37,414 bushels of corn and 251 tons of soybean meal. The 20-7-2 spread would very closely mimic the price risk of the sale of lean hogs while under-hedging the would-be corn and soybean meal inputs by 6.5% and 20%, respectively (see Table A3 in the Appendix). Thus, the speculator should understand this spread underrepresents the feed input price risk faced by producers in the real world. Conversely, a speculator desiring to trade a smaller number of contracts might consider a 5-2-1 spread. This would represent feeding 970 hogs and would over hedge corn inputs by 7% and soybean meal by almost 60% (Table A4 in the Appendix). Using this spread ratio would leave the speculator exposed to greater risk from feed input prices than would exist in an actual hog feeding operation. Therefore, speculators should fully understand the risk profile of an anticipated trade and make adjustments to fit their trading system and risk preferences.

The final piece of constructing a Hog Crush spread trade is choosing the contract months to use for each commodity. In a typical Hog Crush trade, the purchased Corn and Soybean Meal futures contracts have contract months which expire four to five months prior to the expiration of the sold Lean Hog contracts. The exact timing of the contract months depends on the individual producer’s strategy for purchasing cash corn and soymeal.

If the producer purchases all needed corn and soymeal at the beginning of the feeding period, the Corn and Soybean Meal futures contract months should expire at the beginning of the feeding period, or four to five months before the expiration of the Lean Hog futures and marketing of cash hogs. However, if the producer purchases corn and soymeal in the cash market periodically throughout the feeding period, they may prefer to hedge these purchases in multiple Corn and Soybean Meal futures contract months that expire during the feeding period. They may also prefer to hedge with contracts in the middle of the feeding period to protect the average price paid during the feeding period.

Additional considerations should be given to expected liquidity in each of the contract months and to the basis performance of the producer’s local cash market to different futures contract months. For speculative traders, contract months should be chosen based on what will best resemble cash hog feeding practices and what will provide the desired profit and risk profile for a Hog Crush trade.

To avoid physical delivery on the Corn and Soybean Meal positions, those futures contracts should be offset prior to the delivery period. However, hog finishing operations might keep the Lean Hog positions open to provide hedges against the final sales of the finished animal. Some possible Lean Hog-Corn-Soybean Meal spread contract month combinations are in Table 1.

Hog Crush Trading Examples

To assess the value of the Hog Crush, traders subtract the combined values of the corn and soymeal inputs from the value of the lean hogs. For example, with April Lean Hog futures at $80 per hundred pounds, seven futures contracts have a value of $224,000 (seven contracts times 400 cwt. times $80). With December corn at $4.50 per bushel, three contracts are worth $67,500 and a single contract of December soymeal at $400 per short ton is worth $40,000. The total of these feed inputs is $107,500. At the values noted in the example, the 7-3-1 Hog Crush has a positive value of $116,500 ($224,000 - $107,500) and can also be expressed as a positive value of $41.61 per cwt. of lean hogs ($116,500 divided by 400 cwt. per contract times seven contracts, or 280,000 pounds). Remember, this doesn’t represent the true profitability of the hog feeding operation, as there are other costs that were mentioned earlier in this document, that need to be considered.

In July, a hog finisher plans to begin feeding 1,500 hogs in December. If the prices noted above are trading in July, the spread is positive and appears to be favorable to the hog feeding operation. To hedge the risk that the GFM may turn less favorable by December, the hog finisher could put on a 7-3-1 Hog Crush.

In December, the operator will purchase young pigs in the cash market. Prior to the beginning of the delivery period for December Soymeal and Corn futures, the feed side of the hedge will be offset. If by this time feed prices have risen, the operator will realize a gain on the long Corn and long Soybean Meal futures positions, which would offset the higher cost of feed inputs in their local cash market. If the short position in Lean Hog futures is kept in place until the hog carcasses are sold in their local market in April, it will protect the operator from any decline in prices for finished hogs.

The futures margin process is the basis of financial integrity of futures contracts. As such, there are margin requirements on their Lean Hog, Corn and Soybean Meal futures positions. However, the margin (performance bond) on a Hog Crush spread will likely be lower than the sum of the margins for the individual product components, because of the margin spread credit available for this type of strategy. (For the most recent performance bond requirements, visit cmegroup.com/margin).

As mentioned, speculators may also benefit from these Hog Crush trades. Traders who want to use these spreads to feed hogs “on paper” can put on a forward crush. Other traders may prefer to use a contrarian strategy by using a reverse Hog Crush when they believe price relationships differ from historical levels, or if they believe the Hog Crush will improve to more favorable levels. These reverse spreads involve taking opposite futures positions to those that a livestock feeder would use. For example, a reverse crush trader may buy seven Lean Hog contracts while simultaneously selling three Corn contacts and one Soybean Meal contract.

Those who trade a forward Hog Crush try to put on (sell) the trade for as much value as they can and attempt to buy it back for less. Using the example for April Lean Hogs noted above, the forward crush trader hopes that the crush value of $116,500 ($41.61/cwt. of Lean Hogs) will decrease so that the trade can be offset (closed-out) at a profit. If Lean Hog and Corn futures prices decrease to $75 per cwt. with Soybean Meal and corn prices staying unchanged, the value of the seven lean hog contracts will fall to $210,000 while the value of the inputs stays at $107,500. The new crush value is now $102,500 ($36.61/cwt. of Lean Hogs) and the profit is $14,000 ($116,500 beginning value minus $102,500 ending value). Alternatively, the prices for Lean Hog and Corn futures or Soybeal Meal futures could increase while Lean Hog and Corn prices remain unchanged, resulting in a decrease in the crush value. Reverse crush traders attempt the opposite and seek to buy the crush value at a low level and then sell it at a higher level.

The average value of a 7-3-1 crush from 2009 to 2013 was $42.17/cwt. As seen in Figure 2, extreme high and low values of the crush often exist only for short periods of time. If a speculative trader sees what is believed to be an abnormally high value of the crush (say, $55/cwt.), he or she may believe the spread value will decrease in the near future. To profit from this by trading the Hog Crush, the trader would enter a forward crush by selling seven Lean Hog futures contracts and buying three Corn and one Soybean Meal futures contract. In so doing, the trader is positioned to take advantage of falling Lean Hog futures prices relative to Corn and Soybean Meal prices. The trader could also benefit from rising Lean Hog prices, providing Corn and Soybean Meal increase more rapidly than Lean Hog prices do.

To illustrate this further, suppose it is July and Lean Hog futures prices are $85/cwt., Corn is $4.25/bushel, and Soybean meal is $400/cwt. The value of a 7-3- 1 Hog Crush (seven Lean Hog contracts, three Corn contracts, and one Soybean Meal contract) is $134,250 (or $47.95/cwt. of Lean Hogs) at these prices. If a trader anticipates hog feeding will become less profitable in the near future, a forward crush would be traded with seven Lean Hog contracts sold and three Corn contracts and one Soybean Meal contract purchased. Conversely, if a trader believes this crush margin will rise (hog feeding will become more profitable or lean hog prices will increase relative to corn and soybean meal), the trader would enter a reverse Hog Crush and buy seven Lean Hog contracts while simultaneously selling three Corn contracts and one Soybean Meal.

Now suppose by December, all prices have risen and the value of the 7-3-1 spread is now $133,015 ($47.51/cwt. of Lean Hogs). If a trader in July had entered a forward crush (selling Lean Hog futures and buying Corn and Soybean Meal futures), the trader would have experienced a profit of $1,235 ($0.44/cwt. of Lean Hogs) upon exiting the trade in December. Conversely, a trader entering a reverse crush (buying Lean Hogs and selling Corn and Soybean Meal) would have experienced a loss of -$1,235 (-$0.44/cwt. of Lean Hogs). This example is shown in Table 2.

Note, whatever position you are taking in the Lean Hog futures contract is the same position you are taking with the Hog Crush Spread. Example, if you are selling Lean Hogs and buying Corn and Soybean Meal, you are selling the Hog Crush spread.

Conclusion

The price interactions between Lean Hog, Corn, and Soybean Meal f utures contracts offer unique opportunities for hog producers to estimate the profitability of their hog operation and manage risk associated with feed costs, animal sales and their profit margins. Using futures prices as components in the GFM for hog finishing operations provides an excellent forecast of future hog production. The GFM is easily customizable to an individual operation in a particular location by changing basis and production parameters. The price risk in the GFM can be offset in the futures market through trading the hog feeding spread, or “Hog Crush”.

Additionally, the Hog Crush spread also offers opportunities for speculators to simulate the risk exposure of hog feeding and to profitably trade agricultural futures spreads at reduced capital costs. There are many different ways to structure Hog Crush positions (e.g. varying the ratio of contracts traded, contract months, etc.). Traders can also structure Hog Crush spreads to meet their riskreward objectives, to fit a particular trading system or to fit their market expectations.