Buying (Going Long) Pork Bellies Futures to Profit from a Rise in Pork Bellies Prices

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Contents

Buying (Going Long) Pork Bellies Futures to Profit from a Rise in Pork Bellies Prices

If you are bullish on pork bellies, you can profit from a rise in pork bellies price by taking up a long position in the pork bellies futures market. You can do so by buying (going long) one or more pork bellies futures contracts at a futures exchange.

Example: Long Pork Bellies Futures Trade

You decide to go long one near-month CME Frozen Pork Bellies Futures contract at the price of USD 0.8470 per pound. Since each CME Frozen Pork Bellies Futures contract represents 40000 pounds of pork bellies, the value of the futures contract is USD 33,880. However, instead of paying the full value of the contract, you will only be required to deposit an initial margin of USD 1,890 to open the long futures position.

Assuming that a week later, the price of pork bellies rises and correspondingly, the price of pork bellies futures jumps to USD 0.9317 per pound. Each contract is now worth USD 37,268. So by selling your futures contract now, you can exit your long position in pork bellies futures with a profit of USD 3,388.

Long Pork Bellies Futures Strategy: Buy LOW, Sell HIGH
BUY 40000 pounds of pork bellies at USD 0.8470/lb USD 33,880
SELL 40000 pounds of pork bellies at USD 0.9317/lb USD 37,268
Profit USD 3,388
Investment (Initial Margin) USD 1,890
Return on Investment 179.2593%

Margin Requirements & Leverage

In the examples shown above, although pork bellies prices have moved by only 10%, the ROI generated is 179.2593%. This leverage is made possible by the relatively low margin (approximately 5.5785%) required to control a large amount of pork bellies represented by each contract.

Leverage is a double edged weapon. The above examples only depict positive scenarios whereby the market is favorable towards you. If the market turn against you, you will be required to top up your account to meet the margin requirements in order for your futures position to remain open.

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Bull Call Spread: An Alternative to the Covered Call

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Dividend Capture using Covered Calls

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Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

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What is the Put Call Ratio and How to Use It

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Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

Buying Pork Bellies Call Options to Profit from a Rise in Pork Bellies Prices

If you are bullish on pork bellies, you can profit from a rise in pork bellies price by buying (going long) pork bellies call options.

Example: Long Pork Bellies Call Option

You observed that the near-month CME Frozen Pork Bellies futures contract is trading at the price of USD 0.8470 per pound. A CME Pork Bellies call option with the same expiration month and a nearby strike price of USD 0.8500 is being priced at USD 0.0600/lb. Since each underlying CME Frozen Pork Bellies futures contract represents 40000 pounds of pork bellies, the premium you need to pay to own the call option is USD 2,400.

Assuming that by option expiration day, the price of the underlying pork bellies futures has risen by 15% and is now trading at USD 0.9740 per pound. At this price, your call option is now in the money.

Gain from Call Option Exercise

By exercising your call option now, you get to assume a long position in the underlying pork bellies futures at the strike price of USD 0.8500. This means that you get to buy the underlying pork bellies at only USD 0.8500/lb on delivery day.

To take profit, you enter an offsetting short futures position in one contract of the underlying pork bellies futures at the market price of USD 0.9741 per pound, resulting in a gain of USD 0.1240/lb. Since each CME Frozen Pork Bellies call option covers 40000 pounds of pork bellies, gain from the long call position is USD 4,960. Deducting the initial premium of USD 2,400 you paid to buy the call option, your net profit from the long call strategy will come to USD 2,560.

Long Pork Bellies Call Option Strategy
Gain from Option Exercise = (Market Price of Underlying Futures – Option Strike Price) x Contract Size
= (USD 0.9740/lb – USD 0.8500/lb) x 40000 lb
= USD 4,960
Investment = Initial Premium Paid
= USD 2,400
Net Profit = Gain from Option Exercise – Investment
= USD 4,960 – USD 2,400
= USD 2,560
Return on Investment = 107%

Sell-to-Close Call Option

In practice, there is often no need to exercise the call option to realise the profit. You can close out the position by selling the call option in the options market via a sell-to-close transaction. Proceeds from the option sale will also include any remaining time value if there is still some time left before the option expires.

In the example above, since the sale is performed on option expiration day, there is virtually no time value left. The amount you will receive from the pork bellies option sale will be equal to it’s intrinsic value.

Learn More About Pork Bellies Futures & Options Trading

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Buying Straddles into Earnings

Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

What are Binary Options and How to Trade Them?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]

Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

Can You Still Invest In Pork Bellies? The Trade Explained In 2020

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Last Updated on August 12, 2020

Why Are Pork Bellies Valuable?

Pork bellies are cuts of meat taken from the pig’s stomach. The high fat content of this cut makes it ideal for producing bacon.

Pork bellies have a long and storied tradition in financial markets. In 1961, their commoditization ushered in the first livestock trading markets on the Chicago Mercantile Exchange (CME). Over the years, they attracted a wide following from market analysts and traders eager to try to profit from the ups and downs of this niche market.

In 2020, the CME announced the end of pork bellies trading on its exchange. Extreme volatility coupled with dwindling trader interest made the product no longer relevant to financial markets.

However, pork bellies and bacon remain dietary staples for many people around the world, and demand for these products remains robust. For this reason, prices for pork bellies still influence global commodity markets.

Why Did Pork Bellies Become a Commodity?

The market for pork bellies started as a result of Americans’ love affair with bacon.

Before the advent of a transparent futures market for pork bellies, pork manufacturers experienced wild swings in their cost of producing bacon. The reason for this volatility was the seasonal nature of bacon demand in the United States in the 1950s and 1960s.

Although hog farms produced a steady supply of pork year-round, demand for particular cuts of pork varied by the calendar. In the hot summer months, Americans grilled more foods and used bacon as a topping on items ranging from summer salads to hamburgers. In the cold winter months, demand for bacon declined.

Pork producers aware of these seasonal fluctuations began buying, freezing and warehousing pork bellies. The idea was to smooth out their production costs and make their profits more predictable.

Once a Pig Was Butchered, the Pork Belly Would Be Stored in a Freezer – Image via Pixabay

Since pork bellies can be frozen for up to a year, the idea made economic sense. Not only could pork manufacturers insulate themselves from seasonal fluctuations in bacon demand, they also could protect against other supply shocks such as declines in hog production.

Ultimately, the growing interest in buying and selling pork bellies ushered in the pork belly futures contract on the CME.

Traders looking to capitalize on arbitrage opportunities began trading contracts to buy and sell standardized lots of pork bellies in the future. A standard lot consisted of a 40,000-pound frozen slab made up of eight- to 18-pound individual cuts. These standardized contracts provided traders, slaughterhouses and manufacturers with a transparent market for pricing pork bellies and conducting business.

Over the years, the seasonal patterns of bacon consumption became less pronounced. Americans began consuming more bacon year-round for a variety of reasons:

  1. Migration and demographic shifts resulted in more Americans moving south to states with less extreme seasonal weather differences.
  2. The fast-growing Latino population in the United States has fueled year-round demand for pork products including bacon.
  3. Americans are dining out more and the food service industry is supplying more recipes with pork bellies.
  4. The Pork Board, a leading industry group, is promoting consumption of a variety of cuts of pork including pork bellies.
  5. The growing popularity of Asian foods such as banh mi has created demand for pork bellies.

The unpredictability of seasonal bacon demand may have contributed to excessive volatility and dwindling interest in the CME pork bellies futures contract. However, overall pork belly demand is greater than ever, and pork producers still need to purchase the commodity to satisfy consumer demand.

How Are Pork Bellies Produced?

The production of pork bellies begins on hog farms that raise the animals for food. Modern hog farms have evolved dramatically in recent year as large private and corporate operations have replaced small family farms. The advantages of these mega-farms are two-fold:

  1. Lower production costs: Economies of scale allow farmers to feed pigs more efficiently and better utilize their labor. This results in more affordable cuts of pork for food manufacturers.
  2. Negotiating leverage: Larger farms can enter into better contracts with packing operations – the companies that slaughter, process, pack and distribute cuts of meat such as pork bellies. Packers are usually willing to pay more for hogs if a farmer can offer a consistent supply of the animals.

It takes about six months to raise a pig from birth to slaughter. At the time of slaughter, a typical hog weighs about 270 pounds.

Packing facilities purchase whole hogs from hog farms, slaughter them and process them into a variety of cuts of meat, which they sell to retailers. A typical 270-pound hog will yield a 200-pound carcass with an average of 25% ham, 25% loin, 16% belly, 11% picnic, 5% spareribs and 10% butt.

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