Price risk contributes a major source of revenue and cost variability and may be a determining factor in whether a livestock enterprise is viable or not.
Price risk may be addressed by several tools at the operator's disposal. Among the tools are futures hedges and options. Futures hedges were discussed in our column in the March 26, 2004, issue of Delta Farm Press; option hedges and option strategies will be discussed here.
An option is the right but not obligation to buy (call) or sell (put) a commodity futures contract at a specific price (strike) for a specific cost (premium) on or before a certain expiration date.
The premium of an option is made up of two components: (1) time value — a combination of time to option expiration and market volatility, and (2) intrinsic value — any positive difference between the strike price and current price of the underlying or related futures contract.
There are a number of key points to consider using options for price protection and these are:
The operator must know his breakeven costs to determine if pricing is occurring at a profit or a loss. Hedging deals only with the producer's revenues, and while costs have nothing to do with hedging, if a producer is going to hedge (lock-in) a loss, he should be aware of it, in our opinion.
Basis is used to translate a futures or options price quote into a price that is meaningful to the operator.
Puts are used by short hedgers to protect against falling prices. Calls are used by long hedgers to protect against rising prices.
There is no one strike price that is right for every operator. The level of protection or insurance each person wants or needs is a direct result of his ability to bear risk.
After you buy an option, you then have the following alternatives:
- Sell it back to the market or liquidate it (the price may be more or less than initial purchase).
- Let it expire with no value.
- Exercise the option [require the writer (seller) of the option to create a futures position for you in the stipulated direction and price].
Prices in the cattle market now are in both a short-term and intermediate-term uptrend. All strategies will be considered with rising prices. Current cash price in Arkansas for large to medium frame No. 1 600- to 700-pound steers are $105 to $115 per hundredweight. As a producer, you are concerned prices might fall between now and Oct. 1, when you plan to market your calves.
Some strategies for marketing alternatives are:
Establish a minimum sales price: Buy a put.
This is a simple, straightforward strategy. The operator could buy a slightly “out-of-the-money” October '04 feeder put option at $106 strike for a premium of $5.20 per hundredweight (premiums for different strike prices are quoted daily). An “out-of-the-money” put option has a strike price that is below the current futures market, and a premium that is less than an “at-the-money strike price.”
“At-the-money” means a put or call option that is the same as the current futures market price. The operator would have effective price protection at the strike price $106 minus the put premium $5.20 or an effective net sales price of $100.80 per hundredweight, less the broker's commission.
In other words, the minimum return is $100.80 per hundredweight. There is no price risk.
Establish a minimum sales price and take advantage of rising market prices: Forward contract and buy a call.
If the operator is concerned that prices may continue to rise but wants the security of a sales price already locked in, the cattle can be forward contracted for sale on or before Oct. 1 at a price specified by the buyer. Then the operator could buy an at-the-money call for Oct. 1 selling the call back to the market on or before Oct. 1 if it has any intrinsic value.
The maximum return of this strategy would be the contracted price of the cattle plus the call option's intrinsic value (if any) at sale time minus the broker's commission.
The minimum return if prices fall before Oct. 1 will be the forward contracted price minus the option premium and broker's commission.
Transactions in options carry a high degree of risk and possible financial loss. Buyers and sellers of options should familiarize themselves with the type of option (i.e. put or call) which they contemplate trading and the associated risks. You should carefully consider whether trading is appropriate for you in light of your experience, objectives, financial resources, and other relevant circumstances.
Rob Hogan, Scott Stiles, Kelly Bryant, and James Marshall are University of Arkansas Extension economists. Comments or questions? Call 870-460-1091 or e-mail [email protected].