| MMM 379 | August 31, 1998 |
The feeder calf market is below earlier projections. Calf prices are $10 to $15 per cwt. below predicted levels. Hopes for a fall rally are mixed. Is there an effective way to minimize market risk and obtain the best possible price? Cattlemen have, in the past, used forward pricing and/or futures contracts to control price risk. Options on futures contracts are another marketing alternative that minimizes price risk without some of the problems inherent in futures trading.
Options can be bought and sold in the same manner as futures contracts. Yet by buying options, the cattleman can capture the price protection advantage offered by a futures contract without being significantly penalized if the market moves against his market position. Specifically, he will not be subject to any margin calls.
The "put" option allows its buyer the right, but not the obligation, to be short (sold) in the futures market at a specific price he chooses (the strike price). Put options are purchased for a one-time, up front, cost called a premium. The premium level is dependent upon the price protection (insurance) desired. For example, if the futures contract on feeder cattle was trading at $70 per cwt., the put option buyer would pay more to protect a $70 futures price that he would to protect a $65 futures price.
Cattlemen frequently use put options for insurance to protect feeder cattle selling prices. Put options effectively place a floor under the price received for the cattle. If the cash market moves higher as sale time approaches, the cattleman simply does not exercise the option. He sells the cattle in the cash market realizing the gain. All he loses is the premium originally paid when he purchased the put option. He is not required to pay a margin call as the futures price goes up.
If the futures market price falls, the put option's value to the cattleman becomes apparent. The put option allowed the cattleman to obtain a floor price (minimum selling price) for his cattle. The put option now has value because it represents a sale price higher than what is being offered in the marketplace. The option can now be sold outright for a profit. This profit helps to offset the loss in the local cash market price for his calves.
Let's look at today's situation and evaluate the use of a put option. Suppose a cattle producer plans to sell 100 stocker calves in November at an average weight of 500 pounds. The November 1998 feeder cattle futures contracts are currently trading at $68.03 per cwt. One put option contract (50,000 pounds) would cover the number of calves the producer needs to insure.
The futures contract reflects midwestern prices. Southern cattle producers must localize any futures price to reflect southern conditions. This localization adjustment is called the "basis." Adding the basis to the quoted futures price accomplishes the localization process. The basis is determined by the difference between the local supply and demand situation and conditions in the Midwest. Transportation charges to the Midwest are also an adjustment to the local basis. Estimates for historical basis movements are available in Feeder Cattle Basis in South Carolina 1991-1994, Extension Economics Report, 158, Clemson, Cooperative Extension Service, April 1995.
Carolina's historical basis for 400-500 pound calves in November is plus $4.94 per cwt. This is $4.94 above the November feeder cattle futures contract traded on the Chicago Mercantile Exchange. Thus, the expected price for Carolinas' 400-500 pound calves in November is $72.97 per cwt. ($68.03 futures price + $4.94 basis). This is what a cattle producer might expect the local cash market to pay for a 500-pound calf in Carolina during November in a typical year.
It is still uncertain that the "actual" fall price will be $72.97 per cwt. or that return per head will be $364.85 on a 500-pound calf. Net returns could easily erode with only a slight decrease in price. Many producers can withstand some price decline but would likely want to avoid any significant decline in price.
The cattle producer could "insure" against a steep price decline by purchasing a put option. Just like any insurance the cattleman trades off paying a small premium up front to keep from having a significant loss later. Since November 1998 cattle futures were trading at $68.03 when the $364.85 per head return was estimated, let's assume that he wants to protect a price close to $68 per cwt. His broker tells him that November "put" options are currently available at "strike prices" from $60 to $74 per cwt. on the 50,000 pound feeder cattle contract traded on the Chicago Mercantile Exchange. The market is asking a premium of $1.90 per cwt. for a $68 strike price. (Note: many put options trade at the same time on the same futures contract. To generalize, the higher the protection level or "strike price" the greater the premium or insurance cost). If a $68 level of insurance is purchased, then what local price does this protect? This "local protected price" is called the Minimum Selling Price (MSP). The minimum selling price expected under typical November conditions on a 500-pound calf is $71.07 per cwt. (the selected strike price of $68 per cwt. plus the basis of $4.94 per cwt. less the premium of $1.90 per cwt.).
With the purchase of the put option the operator is insuring $71.07 or better per cwt. or $355.35 per head or better in gross revenue. This minimum selling price is stable as long as our expected basis stays at the $4.94 per cwt. Notice that the expected returns are less than those calculated earlier. This is because of the cost of purchasing the price insurance ($1.90 per cwt.). Also the level of the insurance selected (the strike price) was about three cents below the November futures contract price.
The cattleman must now decide what to do. How can he evaluate
the purchase of this price insurance? How does it work out? Have
we minimized market risk? Table 1 suggests what might occur if
the November futures contract price declines as we approach the
month of November and the impact on the cattle producer's revenue.
Table 2. addresses an increase in the futures prices in November.
| Table 1: November Futures Decline Before Sale 1 | ||
| ITEM ($) | WITH PUT OPTION | WITHOUT PUT OPTION |
| Futures Price (cwt.) | $60.00 | $60.00 |
| Basis (cwt.) | 4.94 | 4.94 |
| Local Price (cwt.) | 64.94 | 64.94 |
| Premium | -1.90 | N/A |
| Option Profit (cwt.) 2 | 6.10 | N/A |
| Net Price Received (cwt.) 3 | 71.04 | 64.94 |
| Net Revenue per Head 4 | $145.20 | $114.70 |
In our example, the cattleman selected a $68 per cwt. strike price. This is close to the current November feeder cattle contract of $68.03. Table 1 shows what happens to net revenue if feeder cattle prices fall to $60 per cwt. between now and November. If you have the right but not the obligation to sell for $68 and the market is $60, then what is the value of that "right?" The right to sell at $68 when the market is $60 is $8 per cwt. However, it cost us $1.90 per cwt. to buy the right (the put option); so our net profit on the option is $6.10 per cwt. Using our example, the cattleman would sell calves in the local cash market and receive a price of $64.94 per cwt. He paid a premium or insurance cost of $1.90 per cwt. The "put" option has provided the cattle producer the right to sell a November feeder cattle futures contract at $68 per cwt. and effective put a floor on his cattle of $71.04 per cwt. ($68 + $4.94 - $1.90).
If the futures market price declines, then so should the local cash market, since the two markets are closely related (the difference being the basis). So the cattle producer would realize a cash sale of $64.94 per cwt. from the local market as the futures price falls to $60 per cwt. and gain an additional $6.10 per cwt. when he offsets his put option. This would be an improved return per head of $30.50.
Using the same example, let's consider a situation where the futures price increases as we reach the November market time. The cattleman has already purchased the put option at a $68 per cwt. strike price at a $1.90 per cwt. premium (Table 2). Let's assume that the futures price increases to $75 per cwt. The put option is now worthless. So, what do you do? Simply subtract the $1.90 per cwt. paid earlier for the price insurance from your local cash market revenues and ignore the put option. This is like paying your car or fire insurance and not having a wreck or your barn burn down. If you had known the barn wasn't going to burn down you wouldn't have bought the insurance. Right? When you buy insurance (always in advance) remember the future is uncertain and risky.
The cattleman's minimum selling price was $71.04 per cwt.,
but the cash market has moved to $79.94 per cwt. The cattleman
simply ignores his right to sell a futures contract (the right
that came with the purchase of the put option) at $68 per cwt.
He is now free to receive the market price of $79.94 per cwt.
He has obtained a price per cwt. for his cattle equal to the local
cash market price less the insurance cost. Even if the market
went significantly higher, the option strategy would always result
in a price $1.90 per cwt. lower than the local market price.
| Table 2: November Futures Increases Before Sale 1 | ||
| ITEM ($) | WITH PUT OPTION | WITHOUT PUT OPTION |
| Futures Price (cwt.) | $75.00 | $75.00 |
| Basis (cwt.) | 4.94 | 4.94 |
| Premium | -1.90 | 0.00 |
| Local Price (cwt.) | 78.04 | 79.94 |
| Option Profit (cwt.) 2 | 0.00 | N/A |
| Net Price Received (cwt.) 3 | 78.04 | 79.94 |
| Net Revenue per Head 4 | $180.20 | $189.70 |
1 Assumes
that the basis does not change as we approach November.
2 The option profit ($-8.90)
is the difference between the selected strike price ($68) and
the ending futures price ($60) less the premium ($1.90). This
negative is offset by a higher local cash market sale.
3 The net price received ($78.04)
is the local cash market price ($75.00+$4.94) less the premium
($1.90).
4 The net revenue per head
($180.20) is the net price received times the weight of the calf
(500-pounds) less out-of-pocket costs of raising the calf ($210).
SUMMARY
Put options are a marketing alternative available to cattle
producers to minimize market risk. This is particularly important
in today's cattle market. Options on futures contracts allow the
cattle producer to capture any advantage offered by a futures
contract without being significantly penalized if the market moves
against his position. The put is a useful market tool since it
can minimize the downside risk of the market while allowing the
producer to participate in any possible market price increases.
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