MANAGING PRICE RISK WHEN BUYING STOCKER CALVES
P.J. Rathwell, Extension Ag. Economist

Stocker calves are “hot.”  The price for lightweight calves (300-400 pounds) in the Carolinas is between $105 and $124 per cwt. (early June, 2001).  This is about $400 per head.  Same weight heifers are priced between $94 and $105 today.  It has been some time since stocker operators had to pay this much for their stocker calves.

Couple the high price of calves with the possibility of a continued drought in the Southeast this year and the decision to buy stocker calves is full of risk and uncertainty.  Table 1 shows the impact on the stocker operator’s breakeven price when the calves’ purchase price is ranged from $90 to $120 per cwt. and the cost of gain goes from $.35 to $.45 per pound of gain.  The breakeven price goes from $65 to $86 per cwt at an average daily gain of 1.90 pounds (Note: at higher ADG’s and a lower cost of gain the breakeven price would be lower.  The opposite is true at lower ADG’s and a higher cost of gain).  It is very apparent what a large breakeven price spread would do to the stocker operator’s potential for making a profit. 

 

Table 1:  Breakeven Prices for Finished Stocker Calves Based on Selected Purchase Prices and Cost of Gain 8
					Selected Purchase Prices ($/cwt)
		$90.00	$100.00	$110.00	$120.00	$90.00	$100.00	$110.00	$120.00	$90.00	$100.00	$110.00	$120.00
In-Weight		350	350	350	350	350	350	350	350	350	350	350	350
Calf Cost (hd)		$315.00	$350.00	$385.00	$420.00	$315.00	$350.00	$385.00	$420.00	$315.00	$350.00	$385.00	$420.00
Days Stockered		150	150	150	150	150	150	150	150	150	150	150	150
Average Daily Gain		2.25	2.25	2.25	2.25	2.25	2.25	2.25	2.25	2.25	2.25	2.25	2.25
Cost Per Pound of Gain		35	35	35	35	40	40	40	40	45	45	45	45
Weight Gained		337.5	337.5	337.5	337.5	337.5	337.5	337.5	337.5	337.5	337.5	337.5	337.5
Out-Weight (cwt)		687.5	687.5	687.5	687.5	687.5	687.5	687.5	687.5	687.5	687.5	687.5	687.5
Total Cost of Gain		$118.13	$118.13	$118.13	$118.13	$135.00	$135.00	$135.00	$135.00	$151.88	$151.88	$151.88	$151.88
Total Cost of Animal		$433.13	$468.13	$503.13	$538.13	$450.00	$485.00	$520.00	$555.00	$466.88	$501.88	$536.88	$571.88
Breakeven Price (/cwt)		$0.63	$0.68	$0.73	$0.78	$0.65	$0.71	$0.76	$0.81	$0.68	$0.73	$0.78	$0.83

Can a stocker operator minimize this risk?  Certainly from the production side there is the possibility of irrigation.  Alternative feed sources are, at times, available to offset feed quantity and quality shortages.  On the market side cattlemen have, in the past, used forward pricing and/or futures contracts to help minimize price risk.  Options on futures contracts are another marketing alternative that minimizes price risk without some of the problems inherent in futures trading.

Stocker operators buying calves for fall delivery can utilize a “CALL” option.  The call option allows its buyer the right, but not the obligation, to be long (bought) in the futures market at a specific price that the stocker operator chooses.  The call option allows the stocker operator to effectively place a “cap” on the buying price he will pay for these calves. 

The “call” option is purchased for a one-time up front cost called a premium (this is different than a futures contract where the buyer must be ready to meet margin requirements).  The premium level is dependent upon the level of price protection (sometimes referred to as the level of insurance) desired.  For example, if the feeder cattle futures contract were trading at $85 per cwt. the call option buyer would pay more to protect an $85 futures price than he would to protect a $90 futures price.

The level of price protection selected by the option buyer is referred to as the “strike price.”   In our example if feeder cattle futures contract was trading at $85 per cwt. there would offered on the market several strike prices ranging around this futures quote.  Each of the strike prices would have a cost (premium).  Strike prices lower than $85 per cwt. would be more expensive than strike prices above $85.

How does the “call” option work?  Remember the stocker operator is trying to place a cap on the price he pays for his calves.  If the purchase price declines as delivery time approaches, the stocker operator simply does not exercise the option.  He buys the cattle in the cash market realizing the benefit of a lower price.  All he loses is the premium originally paid when he purchased the call option.  He is not required to pay a margin call as the futures price declines with the decline in the cash market.

If the futures price increased, the call option’s value to the stocker operator becomes apparent.  The call option allowed the stocker operator to place a cap (maximum purchasing price) for his calves.  The call option now has value because it represents a purchase price lower than what is being offered in the market place.  The option can now be sold outright for a profit.  This profit helps to offset the higher price in the local cash market.

Let’s look at today’s situation and evaluate the use of a put option.  Suppose a stocker operator is planning to buy stocker cattle in October.  He plans to purchase 125 four (cwt) weight steers.  The October 2001 feeder cattle futures contract is currently trading near $91 per cwt.  One call option contract (50,000 pounds) would cover the number of calves the producer needs to insure.

Feeder cattle futures contracts reflect national average prices.  Southern 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 differences 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-pound calves in October ranges from $5 to $10 per cwt. over the October feeder cattle futures contract traded on the Chicago Mercantile Exchange.  Given the strength in the cattle market this year the basis is closer to $10 per cwt.  Thus, the expected purchase price for Carolina 400 pound calves in October is, in our example $101 per cwt. ($91 futures price plus $10 basis). 

It is still uncertain that the “actual” purchase price will be $101 per cwt. or that cost per head will be $404 on the 400-pound steer calf.  The stocker operator’s net returns on these calves could easily erode if fall prices were to increase.  Most stocker operators could withstand some price increase but would likely want to avoid any significant increase in price.

The stocker operator could “insure” against a steep price increase by purchasing a call option.  Just like any insurance the stocker operator trades off paying a small premium up front to keep from having a significant loss later.  Since October 2001 feeder cattle futures were trading at $91 per cwt. let’s assume that he wants to protect a price close to this.  His broker tells him that October “call” options are currently available at “strike prices” from $92 to $96 per cwt. on the 50,000-pound feeder cattle contract traded on the Chicago Mercantile Exchange.  The market is asking a premium of $1.60 per cwt. for the $92 per cwt., “closest to the money” strike price (closest to where the futures contract is trading).  The premium for the strike price furtherest from the money is $0.30 per cwt.  (Note: many call 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 costs).  If a $91 level of insurance the closest we can get to this is to buy the $92 call option.  This dollar difference means that we are self-insuring our purchase price by one dollar.

What local price does this $92 per cwt. protect?  This “localized price” is called the Maximum Buying Price (MBP).  The MBP expected on a 400-pound calf in October is $103.60. (The selected strike price of $92 per cwt. plus the basis of $10 per cwt. plus the premium of $1.60 per cwt.)

With the purchase of the call option the stocker operator is insuring $103.60 or less per cwt. or a purchase price for the calf of $414.40.  This price is stable as long as our expected basis stays at $10 per cwt.  Notice that the expected price is greater than $101 per cwt. quoted earlier.  That is because the level of insurance selected cost $1.60 per cwt. and it was $1 above the current October feeder cattle futures contract price.

The stocker operator 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 price risk?  Table 2 suggests what might occur if the October feeder cattle futures contract price declines to $81 per cwt. as we approach the month of October and the impact on the cattle producer’s revenue. 

 

Table 2: October Feeder Cattle Futures Price Declines Before Purchase
		With Call	Without
Item (cwt.)		Option	Call Option
Strike Price		$92.00	N/A
Futures Price		$81.00	$81.00
Basis		$10.00	$10.00
Premium		$1.60	N/A
Max Buying Price		$103.60	N/A
Local Price		$91.00	$91.00
Net Price Paid		$92.60	$91.00
Option Profit		$0.00	N/A
Net Cost Per Head		$370.40	$364.00
1. Assumes that the basis does not change as we approach October.
2. The net price paid ($92.60) is the local cash market price ($81+$10=$91) plus
the cost of the call ($1.60).
3. The option profit is the difference between the selected strike price ($92) and the
ending futures price ($81) plus the premium ($1.60).  In this case the option
expired worthless since the cost of calves at the local market was well below
the maximum buying price established by the call option.  Calves were
purchased in the local market at $91 per cwt.
4. Cost per head is the net price paid times the weight of the calf purchased.

In our example the stocker operator selected a strike price of $92 per cwt.  This was $1 over the October futures price of $91.  What happens if the futures price falls between now and October?  If you have the right but not the obligation to buy for $92 per cwt. and the market is $81, then what is the value of that “right to purchase?”  The value is ZERO.  The call option is now worthless.  So, what do you do?  Simply add the premium cost of $1.60 per cwt. paid earlier to the local cash price of $91 per cwt. ($81 futures + $10 basis) and ignore the call option.  This is like paying your car or fire insurance and not having a wreck or your barn burn down.  If you had known that the barn wasn’t going to burn down you would not have purchased the insurance.  Right?  When you buy insurance (always in advance) remember the future is uncertain and risky. 

The stocker operator’s maximum buying price was $103.60 per cwt., but the cash market has moved to $91 per cwt.  The stocker operator simply ignores his right to buy a futures contract (the right that came with the purchase of the call option) at $92 per cwt.  He is now free to purchase calves at $91 per cwt. in the local cash market.  His net purchase price is the local cash price plus the $1.60 per cwt. cost of the call option.  Even if the cash price went significantly lower, the option strategy would always result is a new price $1.60 per cwt. higher than the local market price.

Now using the same example, let’s consider a situation where the futures price increases as we approach October.  Table 3 addresses a futures price increase to $101 per cwt. in October.  Remember, the stocker operator has purchased a call option with a $92 per cwt. strike price at a cost of $1.60 per cwt.  Let’s assume that the futures price increased to $101 per cwt.  What is the value of the call option?  Does the call option how have any value with futures at $101?  Yes, the option is worth a net of $7.40 per cwt (current value $9 less $1.60 paid).  The stocker operator’s maximum buying price was $103.60 per cwt. even though the futures price went to $101 per cwt. and the local market price for the calves went to $111 per cwt. the stocker operator had the right to purchase a feeder cattle futures contract at $92 per cwt.  This right, when exercised or sold, gives the stocker operator a net price paid for the calves of $103.60 per cwt. ($92 strike price plus $10 basis plus $1.60 cost of the premium).

 

Table 3. October Feeder Cattle Futures Price Increase
Before Purchase of Stocker Calves
		With Call		Without
Item (cwt.)		Option		Call Option
Strike Price		$92.00		N/A
Futures Price		$101.00		$101.00
Basis		$10.00		$10.00
Premium		$1.60		N/A
Max. Buying Price		$103.60		N/A
Local Price		$111.00		$111.00
Net Price Paid		$103.60		$111.00
Option Profit		$7.40		N/A
Cost Per Head		$414.40		$444.00
1. Assumes that the basis does not change as we approach October.
2. The net price paid per cwt. is $103.60.  This is the strike price plus the basis
plus the cost of the call ($1.60).
3. The option profit is the difference between the selected strike price ($92) and the
ending futures price ($101) minus the premium ($1.60).  In this case the option
at expiration was worth $7.40 per cwt. The producer had the right to buy the calves
at $103.60 when the local market was at $111 per cwt.  Calves were purchased at
$111 and option sold at $7.40; net cost of calves was $103.60 per cwt.
4. Cost per head is the net price paid times the weight of the calf purchased.

When calf prices are “hot” stocker operators can shift some of higher prices onto the futures market through the purchase of call options.  The call option essentially allows the stocker operator to “cap” the amount he will pay for the calf even if market prices continue to rise.

A call option is not magic.  The stocker operator still has “basis risk” or the possibility that relationship between local market prices and the feeder cattle futures market contract is different than in the past (but, basis movement is seldom as large as the risk of price changes).  And, the cost of the call can, for some producers, be considered expensive.  But on balance the call option is a powerful tool in the management of price risk.