To hedge or not to hedge, that is the question: Whether ‘tis nobler in the mind to maybe just go ahead and use forward contracting? But what about using options?
You always hear about these great tools. Then, you start hearing about all the ways you could combine them. Your mouth goes dry, hands begin to sweat, and the room starts to spin. You can see how this can get very complicated, very fast. Without a firm understanding of what these strategies and tools are, it’s almost impossible to understand what benefits they potentially hold for you.
If we step all the way back and look at cattle production, we see there are two types of risks. We call these risks because they are things you can’t control. The first is production risk, a topic that fills endless pages. The second, and current focus, is market risk.
Market risk
As a producer, you are a price taker. The price you receive for your goods is set by the consumers buying your product. Retail markets are price setters in that the consumers buying their goods pay the price set by the retailers.
A cow-calf producer’s consumer is usually a stocker producer or feedyard operation. How do they determine the price they are willing to pay for your cattle? They’ve done the math and figured out their breakeven. This breakeven is the maximum price they are willing to pay based on what they are expecting to receive for the cattle, less the costs expected to incur during their production phase.
What does this mean for you as a producer? You also need to know your breakeven price, not as a maximum price you’re willing to pay but as the minimum price you can receive without taking a loss. This is where having a history of income and expense statements comes in handy. By looking back at your statement history, you can determine your production cost and the minimum amount you can receive for your calves.
Everyone has a different level of risk that they are willing to accept. There are three levels of risk—high, medium, and low—and different strategies tend to fall into one of these risk levels.
The cash market (high risk)
The method with the highest market risk level is strictly using the cash market. With all the discussion about the volatility of today’s cattle markets, someone who is willing to take their chances and sell cattle on the cash market without any risk management plan in place would be considered a risk-seeker or risk-taker. If this is you, it is perfectly fine.
The reason this is considered the riskiest method is that you are at the mercy of the market. If the market goes up, you picked the best method. You didn’t have any extra costs from broker fees or margin calls. On the flip side, if the markets go down, you stand to take the biggest losses, making this the worst method.
The put option (medium risk)
Options give you the choice, but not the obligation, of buying or selling the underlying contract. A “put” gives you the option to sell a contract. A “call” gives you the option to buy a contract. You can also buy or sell a put, and buy or sell a call. Each of these has a purpose, but for now we will focus strictly on buying a put option for feeder cattle. A put is the best way to set a minimum expected price without limiting the potential income from the market going up.
When we buy a put, we pay a premium for a desired strike price. The strike price is the value at which we could be selling a contract should we exercise the option. To calculate the minimum expected price, you take the strike price less the basis and the price paid for the premium per hundredweight (cwt.).
In the hedge example, we had a breakeven price of $134 per cwt. At the beginning of May, the futures market was at $154 per cwt. At this price, the premium for a $134 per cwt. option was very low, due in part to the market being on the rise. For a put, as the market rises, its value will move closer to $0.
Since we only wanted to protect our breakeven, and maybe a little profit since the market is moving up, we are going to buy an August feeder cattle put option at a strike price of $150 per cwt. The higher the strike price goes, the more expensive it will become.
However, because our breakeven is $20 per cwt. lower than where the underlying futures contract is, or at the money, we can buy a put that’s a little above our breakeven. At this strike price, our premium is about $600, or $1.20 per cwt. ($600 ч 500 cwts. = $1.20 per cwt.). If it were at the money strike price, the premium would be closer to $1,500. The minimum expected value we should receive in this example is $139.80 per cwt. ($150 – $1.20 – $9 = $139.80).
Within that first week of owning our option, the markets continued to climb. This led to our option losing value, but we haven’t had to make any margin calls because we haven’t taken a position in the market. As time moved on, the market went up as high as $161 per cwt., down to as low as $141 per cwt. and everywhere in between. When Aug. 1 finally comes, the futures market is at $148 per cwt. We sell the steers on the cash market for $139 per cwt. (remember our -$9 per cwt. basis).
Now, we have a couple of choices. Our put option has a value of almost $1,650. We could sell it back for that value and recover our $600 premium cost plus $1,050 extra. This adds a value of about $2 per cwt. to our cattle ($1,050 / 500 cwts. = $2.10 per cwt.).
This works out because we sold the cattle on the cash market for $139 per cwt. We paid $1.20 per cwt. for the premium on our put but were able to sell it back for $2.10 per cwt. giving us a total value for this strategy of $139.90 per cwt. ($139 – $1.20 + $2.10 = $139.90).
The other choice is to exercise the option and sell a futures contract at $150 per cwt. If we do this, we would immediately buy the contract back at the current price of $148 per cwt. This $2 per cwt. change allows us to make an additional $1,000. The $2 per cwt. loss we took on the cash market was made back through exercising our put option.
The total value for this strategy would end up being $139.80 per cwt. This is because we sold the cattle for $139 per cwt., paid a premium of $1.20 per cwt. and made $2 per cwt. from exercising our option ($139 – $1.20 + $2 = $139.80). If the futures price on Aug. 1 had been $5 per cwt. higher than our strike price ($155 per cwt.), the value of our put option would have been around $200. Because we’re closer to the end of the contract, there is less risk that it will move below our strike price.
We have a couple choices in this scenario. We can sell the put option back and recover some of our costs, about 40 cents per cwt. We could sell the cattle at $146 per cwt. ($155 futures – $9 basis = $146 cash), less the premium of $1.20 per cwt. plus the 40 cents per cwt. for selling the option back, giving us a total value of $145.20 per cwt. Our other choice is to simply not use the option and let it expire. This would return us a value of $144.80 per cwt. ($146 – $1.20 = $144.80).
If the futures price was even higher, the option would have been worth even less but our cattle would be worth that much more, which would have allowed us to capitalize on a higher market price without chancing a loss.
Forward contracting (low risk)
For those who don’t want to leave anything to chance, there’s forward contracting.
With your breakeven price in mind, you find a buyer who is willing to pay you an agreed price above your breakeven price on a set date that the cattle will be delivered. Just remember, while a handshake is good, it’s better to get it in writing.
How does this work out? If the market price were to drop after your deal, you’ve made the best choice. No broker fees and no lost profit. But, if the market price were to go up, you’ve given up the chance to capture that extra profit.
Let’s imagine this is your preferred level of risk. You want to lock in a price now, but you don’t have a buyer lined up to buy your cattle. This is where we turn to the futures markets.
Futures (low risk)
The futures markets are just that: market price projections for future dates.
People from all over the world gather to buy and sell contracts for different commodities based on these projected prices. Each contract is different depending on the commodity. Since we’re talking about cattle, we’re going to use the feeder cattle futures.
In 1971, the Chicago Mercantile Exchange (now the CME Group) added feeder cattle futures to the list of livestock commodities offered. Based on the peak cash market months, contracts were offered for the months of January, March, April, May, August, September, October and November. Because of the price variation between different sizes of cattle, the quoted prices are for Medium and Large #1, and Medium and Large #1-2 feeder steers weighing 700-899 lbs. The total volume for one of these contracts is 50,000 lbs.
This means one feeder cattle contract will cover about 62 feeder steers weighing 800 lbs. As the contract date gets closer, the futures price and cash price start to converge. When the contract closes, the difference between those prices is the basis (Basis = Cash Value – Futures Value). Basis accounts for the form, location, and time aspect of the commodity. The cattle’s weight or gender can affect the basis in the way of form, while the distance the sale is happening accounts for the location.
How do people from all over the world get together and project a price for cattle for a date that falls between the end of the month (or the next month a contract is available, known as the nearby contract) all the way out to almost a full year away?
The futures market is a free market working as it should. As information is made publicly available, traders use this information as they see fit to predict where the new price should be. If the information they have indicates the price is going to drop, they will sell a contract to someone who believes the market is going to go up. This is called taking a short position.
If the market follows their expectations and goes down, they will offset their position by buying back that contract at a lower price, hence the phrase “buy low, sell high.” If the market actually goes up, they will lose money, while the person who took the other position makes money. People who take part in this without producing the commodity or without the intention of buying it are called speculators. For those who are producers or buyers, this practice is called hedging.
When dealing with futures, a margin account is set up and an initial balance is deposited in that account. You must maintain your margin balance in order to keep your position. These initial margin requirements and maintenance levels can differ by brokers.
In the example earlier, a trader speculated the market was going to go down and took a short position. Fortunately, they guessed the market’s movement right; as the market falls, they get money deposited into their margin account.
However, if they speculated wrong and the market went up, for every $1 per cwt. the contract goes up, $500 is taken out of their margin account. At the end of every day, our account is marked to market, meaning the CME will adjust our margin account based on what we made or lost that day. If the balance in that margin account gets too low, a margin call is made telling you a deposit needs to be made. This can become an issue for hedgers if they don’t understand what’s really happening.
Consider the tradeoffs
While the option may sound like the best choice, each choice has a tradeoff compared to another. A hedge is the best choice if the market goes down but the worst choice if the market goes up. The cash market is the best choice if the market goes up but the worst if the market goes down. A put option is second best if the market goes down because of the premium cost but also the second best if the market goes up, again because of the premium cost.
Depending on your level of willingness to accept risk, one of these risk management tools could be useful to you. While these examples provide the general concepts of how they work, the way each affects your bottom line could be different depending on your situation. So, before you call up a commodities broker and dive into the futures markets, sharpen your pencil or open a spreadsheet, and speak with everyone involved, the owner, the manager, your spouse, and your banker, to make sure everyone understands the plan and how it moves. — Jason Bradley, agricultural economics consultant for the Samuel Roberts Noble Foundation
- Basis: Accounts for the deviation in the form, location and time aspect of the commodity from the contract specifications.
- Broker Fees: Commissions paid to the broker who acts as the agent when buying or selling futures contracts or options.
- Futures Market: Where contracts for future deliveries on commodities are bought and sold.
- Margin Account: An account to hold the funds required to have a position in the futures market.
- Margin Calls: Monies that must be sent to the broker firm to maintain a position in the futures market when the market moves against the held position.
- Seller’s Breakeven Price: The minimum price you can receive without taking a loss.
- Strike Price: The designated price level at which an option is traded.
