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

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.

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

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. Support for this pricing relationship is based upon the argument that arbitrage opportunities would materialize if there is a divergence between the value of calls and puts. Arbitrageurs would come in to make profitable, riskless trades until the put-call parity is restored.

To begin understanding how the put-call parity is established, let’s first take a look at two portfolios, A and B. Portfolio A consists of a european call option and cash equal to the number of shares covered by the call option multiplied by the call’s striking price. Portfolio B consist of a european put option and the underlying asset. Note that equity options are used in this example.

Portfolio A = Call + Cash, where Cash = Call Strike Price

Portfolio B = Put + Underlying Asset

It can be observed from the diagrams above that the expiration values of the two portfolios are the same.

Call + Cash = Put + Underlying Asset

Eg. JUL 25 Call + $2500 = JUL 25 Put + 100 XYZ Stock

If the two portfolios have the same expiration value, then they must have the same present value. Otherwise, an arbitrage trader can go long on the undervalued portfolio and short the overvalued portfolio to make a riskfree profit on expiration day. Hence, taking into account the need to calculate the present value of the cash component using a suitable risk-free interest rate, we have the following price equality:

Put-Call Parity and American Options

Since American style options allow early exercise, put-call parity will not hold for American options unless they are held to expiration. Early exercise will result in a departure in the present values of the two portfolios.

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The put-call parity provides a simple test of option pricing models. Any pricing model that produces option prices which violate the put-call parity is considered flawed.

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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. ]

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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.