Some traders are using and advising option spreads to mitigate risk, so Matthew Diersen, risk and business management specialist for South Dakota State University’s Ness School of Management and Economics penned an overview in the Livestock Marketing Information Center’s letter to Extension Agents called In The Cattle Markets.
DEFINITION
Spreads are various combinations of contracts that generally involve buying something and selling something, Diersen said. When a specific commodity, with a specific expiration, and a specific option type is used, it is called a vertical spread. In contrast to buying a put option outright, a vertical put spread would couple the purchase with sale of a put option at a different strike price.
A vertical call spread is used when there is upside price risk to be mitigated, Diersen said. Usually, the option bought is at-the-money (at a strike price that is close to the futures price), and the option sold initially is out-of-the-money (at a strike price that is far away from the futures price). The proceeds from selling an option are used to cheapen or reduce the outlay for the option that is bought.
TRADE OFFS
However, the unlimited aspect of the purchased option is curtailed, he said. A vertical option spread may make sense if there were a specific price range that one seeks to avoid.
A feedlot that is concerned about higher feeder cattle prices, could lock in the price by using futures or protect against higher prices by buying call options, he said. A call option would increase in value as the futures price increases. The cost is dependent on how volatile prices are expected to be until the option’s expiration date.
Recently, the implied volatility of feeder cattle has been falling, Diersen said. The August futures have been trading around $165-$170 per cwt from its February high of $187.
Consider an at-the-money call option at the $170 strike price, he said. At last week’s close, it had a premium of $3.30 per cwt.
Buying that call would give a price ceiling of $173.30 per cwt, regardless of how high futures went, Diersen said. If the price were to fall before August, the feedlot would be out the premium.
A vertical call spread would involve selling a call with a higher strike price, he said. The $180 strike option had a premium of $1.08 per cwt at last week’s close. Selling that option would reduce the outlay to $2.22 per cwt.
However, if the futures price at expiration were to increase above $180, the sold option would have a value that matches the bought option, halting any upside benefits of buying the initial option.
CATTLE, BEEF RECAP
The USDA reported formula and contract base prices for live FOB steers and heifers this week ranged from $139.71 to $140.38 per cwt, compared with last week’s range of $138.39 to $143.18. FOB dressed steers, and heifers went for $217.29 to $218.40 per cwt, versus $216.86 to $220.73.
The USDA choice cutout Tuesday was up $2.12 per cwt at $267.54, while select was up $2.15 at $248.65. The choice/select spread narrowed to $18.89 from $18.92 with 128 loads of fabricated product and 17 loads of trimmings and grinds sold into the spot market.
The USDA reported that basis bids for corn from feeders in the Southern Plains were unchanged at $1.55 to $1.65 a bushel over the Jul futures and for southwest Kansas were steady at even the Jul, which settled at $7.51 1/2 a bushel, down $0.02.
The CME Feeder Cattle Index for the seven days ended Monday was $153.22 per cwt down $0.13. This compares with Tuesday’s Aug contract settlement of $165.12, down $1.20.