As alternatives to hedging and speculating in futures on various commodities, securities similar to stocks have been developed that seek to mimic the price changes of the underlying futures contracts. One of these is the iPath exchange-traded note (ETN) issued by Barclays — the Dow Jones UBS Livestock TR Sub-Index ETN (ticker symbol is COW, of course). The note reflects price changes on two livestock futures contracts — live cattle and lean hogs. The proportional representation in the COW price is approximately 61% cattle and 39% hogs.
Other ETNs linked to livestock include ETRACS Bloomberg CMCI Livestock ETN and Elements MLCX Total Return Index. ETNs have the backing of the issuing institutions, but are not secured debt — thus, there is a certain amount of risk attached to these instruments in addition to the potential lack of liquidity in the ETN market. However, we would be remiss not to consider these markets, particularly when they offer some unique speculative opportunities.
“COW, cattle and hogs” (below) shows cumulative percentage changes in the prices of the ETN and December livestock futures contracts from April 2 to Aug. 17, 2012. It is obvious that neither the futures combination nor exchange traded note has provided spectacular returns over this time period. Cattle and hogs have been negatively affected by the increase in the price of corn because of the extreme drought conditions during the summer months. In the face of rising corn prices, livestock has been sold in large numbers, resulting in a temporary reduction in the prices of meat futures. Because futures contracts provide the base of ETN pricing, the COW has struggled through this period.
Throughout the months shown on “COW, cattle and hogs,” the cumulative percentage price changes for the ETN remain close to cattle price cumulative changes, and only depart from the lean hog cumulative percentage changes beginning in the first week of July. At that time, Barclays pricing formula keeps COW close to cattle futures while hogs show a sharp price decline.
Live cattle and lean hog futures can be combined in a 61%-39% approximation of the ETN proportions. “COW and combo” (below) contains the original cumulative percentage changes of COW ETN prices and the combined prices for December 2012 live cattle and lean hog futures. Normally, with a chart of this type, the purpose is to look for spread possibilities; however, with two price series that are different manifestations of the same underlying assets, it is necessary to explore another trading approach. The two series tend to rise and fall at the same time with slightly different highs and lows.
Because of how the price changes are situated, the combo may be used to forecast changes in the COW ETN price. Because COW is calculated off of live cattle and lean hog futures, the cause and effect for price changes must run from combo to COW. It is easy to think of combo as the COW’s shadow. You cannot outrun your shadow, and neither can the COW price stray too far from the combination of cattle and hog futures prices.
The combo is an estimated index used in conjunction with Barclays’ formulation of the COW price. However, “COW and combo” implies a close fit between changes in the two price series. The shadow approach may give an edge to a trader of the COW ETN.
Exploring options
Options may be used to leverage potential gains based on ETNs. For example, on Aug. 24, 2012, finance.yahoo.com listed COW puts and calls with four expiration dates ending at April 2013. “January 2013 COW calls” (below) is the regression curve analysis based on ask prices for six calls. Delta, the change in the call price per unit change in the ETN price, extends from 0.036 for out-of-the-money options to 0.876 for in-the-money.
Upper and lower breakeven prices are COW expiration prices that would result in a current delta spread with no profit or loss. Volatilities described by the breakeven spreads as percentage of strike prices, and implied volatilities calculated by the Black-Scholes option price model, show that the volatility curves are skewed — higher at each end and lower where the strike price equals the underlying asset price. A similar pattern of skewness appears on “Cattle volatility smiles” (below). Breakeven spread percentages for the different strikes follow smooth curves down toward a ratio of 0.96 for futures price-to-strike price.
When we analyze live cattle and lean hog call options for three expiration dates on Aug. 24, 2012, we see that the two highest curves belong to October and June lean hogs, while December live cattle forms the bottom curve. In the middle are December hogs as well as October and June live cattle. The cattle price curves are close enough together that the small difference may have suggested calendar spreads on Aug. 24, selling June live cattle futures and buying October.
Heights of the option price curves as a percentage of the strike price that equals the current December futures price indicate the comparative volatilities shown below:
| Expiration | Lean hogs | Live cattle |
| December 2012 | 4.42% | 2.64% |
| June 2013 | 6.21% | 3.88% |
| October 2013 | 6.93% | 4.41% |
“COW and combo” showed that the two price series move closely in terms of percentage price changes, so we should find that their volatilities are similar. On Aug. 30, 2012, a Black-Scholes option price evaluation resulted in the standard deviation of annual returns for the January 2013 COW calls of 0.120. A similar analysis of December 2012 live cattle and lean hog call options showed standard deviations of 0.111 and 0.215, respectively. A weighted average of the livestock implied volatilities is 0.152. Thus, the volatilities are similar as they should be, with the combo result perhaps elevated because of the recent movement in lean hog futures.
Continuing analysis of the COW, live cattle and lean hog price changes should produce profitable trades. The universe of ETNs is large, and the same analysis might be applied to an increasing number of exchange-traded securities whose values depend on a wide range of underlying assets. In any case, the objective is not a completely accurate matching of the ETN price movements, but instead an estimate that includes the primary causes of ETN price changes.
Paul Cretien is an investment analyst and financial case writer. His e-mail is PaulDCretien@aol.com.
