By Justin Gleghorn, Risk Management Consultant Brock Thompson Trading
Price activity in the feeder cattle market has been bearish since the middle of August. Historically, this should not be surprising as the feeder cattle contracts tend to post highs in late spring through late summer (scroll down to see figure 1 below).
It cannot be argued that although we have the smallest cattle inventory in recent history and beef production for 2009 is 3.1% below 2008 and 2.5% below the five year average, prices are under pressure. Additionally, last week has been a volatile week in the corn market and the feeder market was rather unresponsive to any of these moves in the corn market. Rather it be outside markets or demand issues pressuring the cattle prices, we have not observed increases in prices that might be expected.
Given the uncertainty, steps should be taken to minimize the risk exposure. Options provide coverage where risk can quantified easily. Basically through the use of puts or calls a producer can limit their loss to the premium paid for either option.
Currently, a stocker operator may wish to protect against a price increase in stockers that will be procured in late fall or early winter and can use call options to hedge against price increases. By purchasing a call in a given month at a specific strike price the producer has paid for the right, but not the obligation to take a long position the market. Therefore if prices increase above the strike price of the call option purchased, the option can be exercised and he is given a long position. He can offset the long position and use the profit from the long hedge strategy to offset the higher price paid in the cash market, realizing basis adjustments have to be accounted for. This strategy may be used throughout the remainder of the year if the producer believes the market will not continue in a downtrend.
Conversely, if a producer has cattle on hand and wishes to protect against price declines they can use a put option to protect against these declines. Similar to a call option, the producer will choose a specific price in a specific month and purchase the right, but not the obligation to take a short position in the market if price declines to a level below their strike price. The producer can use the profit made in the futures market to help offset declines in the cash market.
In both instances, the maximum risk is limited to the premium paid for the options. Therefore, the upside potential is not limited as it would be is outright hedge positions were taken in the futures market. Although the price of the option always has to be accounted for, if the market moves in favor of the producer in either instance they can take full advantage of the price move as long as the move exceeds the cost of purchased option.
Justin Gleghorn is a risk management consultant with Brock Thompson Trading in Amarillo, Texas. You can reach him via e-mail at email@example.com
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