Beef magazine recently ran a series of articles by private industry consultant Nevil Speer in which he discussed the basics of using futures and options to help cattle producers better understand the mechanics of implementing risk management.
Beef has graciously allowed us to re-run those articles. This is the second of the series, edited for space and style.
JUST THE FACTS
First, it’s helpful to provide some definitions:
- Futures contract: standardized contract obligating participants to make (or take) delivery
- Options contract: right to buy (call option) or sell (put option) underlying futures contract
- Strike price: price of underlying contract at which call or put option would be exercised.
- Premium: price of option.
Here, the focus is on risk management for fed cattle, and because we’re looking to implement risk management on the selling (“short”) side, the discussion highlights the use of put options.
Purchasing a put provides price insurance for a cost (the premium) by establishing a price floor for sellers and allowing them to retain the ability to capture upside price movement.
FOLLOW THE MONEY
The last article used cattle placed on feed from mid-November to mid-December to be marketed in early to mid-May (against the June live cattle contract). At the time of placement, a $114 (strike price) June live cattle put cost $4/cwt.
That purchase allowed the feedlot to sell the underlying futures at $114/cwt if desired. But because the put cost $4/cwt, the net selling price would be $110/cwt if exercised.
THERE’S THAT BASIS AGAIN
During the past five years, May’s basis average has been a positive $9.75. Based on this, the expected selling floor would be $114/cwt (futures contract), less $4/cwt (cost of option contract), plus $9.75/cwt (positive basis), yielding a net $119.75.
The put would be exercised at any point in which the futures market at sale time is LESS than $114 when the put would be “in the money”, or profitable.
If the futures market rises above $114, the put would NOT be exercised because it would be “out of the money,” and the seller can take advantage of upside potential in the cash market (although always $4/cwt behind cash because of the initial cost of the put).
But, basis risk is always present: fed cattle basis (cash minus futures) declined from $9.75 in early May to $6.50 two weeks later and will erode seasonally as the June contract’s expiration approaches.
All the principles around the put still exist, but the absolute selling price is proportionally less because of the declining basis. That is, with a $6.50 basis, the floor is now $116.50 ($114/cwt put, less the $4 put cost, plus the $6.50 basis).
A couple of principles are important when considering the purchase of any option contract:
- Option values (not the strike price) inherently decline over time as their expiration nears.
- Increased market volatility increases the value of options.
CATTLE, BEEF RECAP
Cash cattle traded in the Plains last week at $112 per cwt on a live basis, up $1 to down $2.50 from the previous week with trades up to $115 to $116 in Iowa. Dressed-basis trading appeared at $183 with some up to $185 in Iowa, steady to up $1.
The USDA choice cutout Monday was up $1.09 per cwt at $213.26, while select was up $1.42 at $189.76. The choice/select spread narrowed to $23.50 from $23.83 with 65 loads of fabricated product sold into the spot market.
The CME Feeder Cattle index for the seven days ended Friday was $141.50 per cwt, up $1.92 from the previous day. This compares with Monday’s Aug contract settlement of $142.30, down $1.42.
IN OUR OPINION
–Weather forecasts for the Corn and Soybean Belt remain relatively dry for the next few days, although somewhat cool. Corn futures are sagging as a result, but condition ratings also are below average. This continues to be a weather market on steroids as it lacks data on acreage planted, and increasing numbers of traders are beginning to worry about an early frost.
–US/China trade talks have resumed in Shanghai, but the US is downplaying its expectations for any significant gains. Meanwhile, Meatingplace reported that the Chinese government has announced a program that mandates a boost in domestic pork production after losing 13 million tonnes of pork production in the last year because of African Swine Fever. It’s hard to “mandate” increased production of pork when the reason it was lost in the first place is a disease like ASF.