Livestock, grain producers can use futures, options, hedges to manage risk
Anyone who is involved in agriculture will agree there are all kinds of risks. Some live by the mantra “with risk comes reward,” while others don’t like risk.
One thing to consider as a farm or ranch operator is the business’s tolerance for risk, and some of the tools available to help offset some of those risks, like futures and options contracts, for example.
“There are all kinds of risks in agriculture,” says Northwest College professor of agribusiness Jason Horton. “While you’re growing the crop, or while the calves are growing, what happens if the price goes down?”
Horton says there are three options when it comes to risk in any business – assume the risk, avoid the risk or transfer the risk. He says there are several tools for managing price risk, and the one with which most farmers are ranchers are familiar are forward contracts. Futures contracts, options contracts and swap contracts are also available.
In forward contracts, two parties agree on contract terms and set a price for the product. Horton says is the contract includes a re-trade clause it’s considered strong.
“That says whether or not you can sell the contract to someone else,” he explains. “A re-trade clause helps with liquidity – one of the key elements in your futures contracts and futures options.”
Regarding futures contracts and options, Horton says they’re traded on a central exchange and regulated by the Commodity Futures Trading Commission.
“The contract terms are pre-specified and standardized – a key element,” he describes. “A futures contract is an agreement to buy or sell a specified product for a specified price at a specified place at some specified point in time. As a buyer you have to look at the product yourself – you know what you’ll get, and all the contracts are re-tradable, which adds to liquidity.”
In using futures contracts to manage risk, Horton says there are two ways to manage the risk – either as a way to buy or as a way to sell a cash commodity. He says only about two percent of futures contracts are ever actually delivered – very little of the commodity actually trades through futures contracts.
“Hedging allows a business to operate within the normal cash markets and futures markets simultaneously, therefore managing the risk of price change,” he states, adding that the futures contract is a derivative of the cash market.
Explaining options, Horton says the buyer of an option has the right, but not the obligation, to do something, while the seller has the obligation to perform as specified in the agreement.
“The two terms used are ‘call’ and ‘put,’” says Horton. “They buyer of a call has the right, but not the obligation, to buy. A put gives me the right to sell something. A term is the premium – what the buyer pays for the right to purchase. The strike price is the price at which they’ll buy or sell the product, and it’s already been negotiated when one exercises an option.”
Horton says there are two types of options – an exchange-traded option on futures contract, or over-the-counter, where a buyer will purchase a physical product. Either way, the buyer can exercise the option or let it expire, and all he’s out is the premium he paid for the option.
“An option on a futures contract is a double derivative,” says Horton. “An options contract is determined by the futures contract, which is determined by the cash price.”
How are those tools used together to eliminate price risk? Horton says hedging is the process of using futures, options and swaps to manage price risk.
“Hedging is having two or more positions in different markets so the loss in one is offset by a gain in another,” he notes. “The bets offset each other by having two opposite positions in markets that trend together.”
He explains the cash and futures markets tend to trend together, which allows the cash market to be managed with the futures market.
“They might not move exactly together, but they trend in the same direction,” he notes.
“Hedging is having opposite cash and futures positions, and the hope is the losses exactly cover the gains. You’re not trying to gain or lose money – we said we’re happy with a set price, and that’s what we want, and that’s the overall goal we’re trying to get to,” explains Horton of the hedging strategy. “If I take out a hedge on cattle, I say I’m happy with the price, and if the price skyrockets I miss out on all that, but if it tanks, I miss out on that, too”
“Many people think they know where the market’s going, and they can buy an option and use it to make money,” says Horton. “Position, or directional, speculators are traders who try to guess the direction the prices will move.”
“If you’re a rancher and have calves growing, and don’t have any hedge or insurance set up to control the price risk, you’re speculating,” he says. “If prices move in your favor, you’ll make more, or you could make less. You’re assuming that risk.”
Some traders attempt to profit from their knowledge about the relationships between two or more markets. Horton says there are thousands of people willing to buy or sell futures contracts.
“That gives us a lot of liquidity. We can buy or sell futures contracts in about three minutes over the phone. Being in and out of the market is very quick, and futures contracts have long been the standard for price risk management,” he says, adding that standardization gives futures contracts the ability to be easily re-traded.
The full value of a contract generally does not have to be advanced to get control of the market. Horton gives the example of raising calves and purchasing a contract for feeder cattle.
“It’s $50,000 for the value of the market, but I can send in a margin of around 10 percent, so a $5,000 check,” he explains. “I’m trading $50,000 worth with $5,000 of skin in the game. It’s called the margin, which is set by the exchange. If a contract’s value changes, the buyer is responsible for additional losses, known as the margin call. If I don’t have the money, he sells me out, and that’s one way to keep default risk out of futures contracts.”
Basis is the difference between the futures and cash price. “The importance in hedging is how the prices relate to each other,” says Horton. “The relative price movements are known as basis risk. Hedging removes the risk of absolute price movements and replaces it with basis risk.”
He adds that a perfect hedge has no basis risk – imperfect hedges have beginning and ending basis that are different. He says there’s a little difference between managing price in grain and livestock, because grain can be kept in a bin for some time, while a pen of cattle can’t be kept long without changing form, even on a maintenance ration.
Also, he says higher value uses for major crops necessitate a higher understanding of price risk management.
“Grain isn’t just for food anymore. If you’re looking at the markets, you need to know what they’re tied to. Energy prices are closely tied to grain prices now, and if the price of oil runs up, so will grain prices,” he states.
On using futures in the livestock industry, Horton says livestock have a rich history in the futures market, and that live animals have a basis that does not follow the cost of carry.
“Live animals go through a process that subjects them to the risk of price decline – you can’t sell them the day they’re born,” he says. “Only slaughter-ready animals can be hedged in the hog market, and feeder and live animals can be hedged in the cattle market.”
On a cow/calf hedge, Horton describes a scenario that estimates 142 calves to sell in the fall, so a producer would take a short hedge and sell two November feeder cattle contracts at $75/cwt.
“The prices go up and down, but it doesn’t matter. He ends up selling 144 head at 605 pounds, a total of 87,120 pounds, at $75 on the cash market,” he says. “He has to make a round turn and get out of his position in the market, so he buys back at $68/cwt. and had a positive seven-dollar basis. He made $65,340 on the calves in the cash market, plus $7,000 in futures, so his total was $83.03 cwt.”
For those who would rather transfer their price risk than assume it themselves, Horton says using futures, options and hedges is a good tool to transfer that risk to someone else.