Imagine we want to lock in a price like forward contracting would do, but we don’t have a buyer. We let the futures market become our buyer.
Let’s assume the basis is going to stay constant, we don’t have brokerage fees, and it is the beginning of May. We plan to sell 62 feeder steers weighing 800 lbs., or one contract worth of feeder cattle. We know we want to sell these steers at the first of August. We’ve calculated our breakeven to be $134 per hundredweight (cwt.). Therefore, we are watching the August feeder contracts go above our breakeven.
It just so happens the cash price for an 800-lb. steer at our local sale barn on that day is $145 per cwt., but the August futures price is above our breakeven by $20 per cwt., so we decide to hedge and sell one August feeder cattle contract for $154 per cwt.
We deposit our initial balance—say it’s $4,000—into our margin account. Our maintenance margin is $3,000, so we’ll have to keep the balance at that amount or above. Looking at Figure 1, we can see the market moved up to $160 per cwt. within a few days of selling that contract.
By the end of the first week, we’ve already had to pay an extra $2,000 into our margin account just to keep at the maintenance level. This may feel like a bad decision, but when we look at what’s happened on the cash market, the price of our cattle has gone up as well. So that $2,000 we paid into the margin account is going to come back to us when we sell the steers on the cash market.
As time moved forward, we can see from the figure that the market fell to $150 per cwt. shortly after. As the market moved down, our margin account was credited the $3,000 we lost in the first run up, as well as an additional $2,000 as the market dropped below the price at which we sold. That’s more like what we’re wanting, right? Not really. On the cash market, the value of your cattle has dropped as well.
As we fast forward to the beginning of August, the market moved back up then down again, finally settling around $148 per cwt. No extra margin calls were needed, and we sell the steers for $139 per cwt. ($148 per cwt. from the futures – $9 per cwt. from the basis = $139 per cwt. on the cash market).
As soon as we sell the cattle, we need to offset our hedging position. If we hold onto the position longer than we have the cattle, we become speculators. We get back the losses we took in the cash market from the gains we made in the futures market, but we also get back the balance in our margin account.
Reviewing what we have done, our initial cash market value was $145 per cwt. On May 1, we sold an August feeder cattle contract for $154 per cwt. On Aug. 1, we sold the cattle on the cash market for $139 per cwt. Last, we offset our futures position by buying back an August feeder contract for $148 per cwt. The total value we get back is $145 per cwt. ($154 + $139 – $148 = $145).
One thing that makes hedging a challenge is when you have to make multiple margin calls. This cuts into your available capital. Make sure you understand you will get the capital back in the end through the cash market price.
Brokerage fees are a cost we did not include in this example. These fees end up adding a cost of 10-20 cents per cwt. to a feeder contract. We also assumed a constant basis. While this would be nice, the final basis is an uncertainty but not as volatile as the cash market.
Therefore, while we limited ourselves to any potential losses in a down market by hedging, we also limited ourselves to any potential gains in an up market. Is there an option that gives us the opportunity to prevent any losses but not prevent any extra gains? Yes, it’s called just that: an option. — Jason Bradley, agricultural economics consultant for the Samuel Roberts Noble Foundation
