Options and futures provide possible price risk mitigation tools for livestock producersWritten by Natasha Wheeler
Worland – Livestock producers do not commonly use futures and options, but University of Wyoming Extension Educator Bridger Feuz believes they may be something for producers to consider, especially with the volatility of the market forecast for coming years.
To illustrate livestock producers’ attitudes about futures and options, Feuz noted, “As part of his class, my brother gives students an account of fake money and asks them to trade on the futures and options market as part of their grade. The first year he did that, he could hardly get any of the kids to trade, even with fake money.”
Students were too nervous to enter the market, and now, the assignment includes a mandatory number of trades per week to earn a passing mark.
“As livestock producers, we haven’t necessarily been that comfortable with futures and options as a tool to manage risk – not nearly as comfortable as folks with grain,” Feuz continued.
Yet, price risk is real for any agricultural producer. The price of one 650-pound steer, for example, can change dramatically from week to week, or even day to day.
Futures and options provide one form of risk management tool that can be employed in the cattle business.
“The tool that is best for a producer depends on their operation and personality,” Feuz said.
Livestock producers typically remain in the cash market, staying out of the futures market and avoiding insurance products.
“We should use the tools we are comfortable with, but it also takes practice to become familiar with the tools we use,” he remarked. “Working with an expert, like a good broker or the right insurance salesman, can make a difference.”
Some ways that producers can use the market as a risk management tool include using hedging, put options or Livestock Risk Protection (LRP) insurance.
Hedge against futures
“If we are sitting around in the spring and thinking about selling calves in the fall, there are no guarantees for what the price might be. It’s going to move, change and go up or down. One thing producers can do is place a true hedge on their cattle,” Feuz suggested.
A hedge locks in a guaranteed price for the cattle when they sell, no matter how prices fluctuate in the market.
“We are insuring against price risk, but we aren’t insuring against basis risk. We do need to understand basis a little bit,” he warned.
Basis refers to the difference between the national price index and the local price index. It can be different than the cash price, and it usually doesn’t change as much as cash.
“Why don’t producers hedge?” Feuz asked. “It’s tough for us to lock in a price when we know the price could be higher when we sell. The other thing is margin calls. As the market moves against us, our broker can call and tell us they need more cash to keep our position in the market.”
One of the worst things that a producer can do is to send cash for a margin call or even a number of margin calls, before panicking and removing their hedge, or position.
“When we do that, we lose our margin, and we lose in the market. If we hedge, we have to have the cash flow or a banking partner who understands what we’re doing and who will back us on those margin calls, and once we hedge, we have to stay in it. We can’t pull out,” he stated.
One of the other challenges with options is the size of the contracts, which are written in 50,000-pound terms. Few producers have the exact figures to meet that weight.
“If I have 75,000 pounds of calves, do I under-insure them and buy one contract for 50,000 pounds or do I buy two contracts for 100,000 pounds?” he asked.
Options and insurance
A put option is another way to use the market. Instead of hedging cattle on the futures market, a producer can buy an option to take a position at a later date. If the cash price falls below a certain mark, the producer can then choose to exercise the option for the price he or she has locked in.
“We lock ourselves into a floor price without taking away the option of the upside price. Options are a little more enticing to producers, but again, there are lumpy contracts,” Feuz explained.
LRP insurance is another option, which works similarly to put options.
“We are buying an insurance product instead of an option in the market. LRP insurance is based on the futures markets,” he noted.
A premium is paid to insure a certain coverage level for the cattle, and if there’s a wreck, the producer can collect the indemnity. If the price goes up, the premium has already been paid, and the producer does not collect any additional money.
“If we’re looking at any of these price risk tools, particularly insurance, we want to use it as a tool to manage risk, not as a money-making strategy,” Feuz warned.
Comparing it to truck insurance, Feuz commented that no one wants to wreck their new truck just because they bought insurance to cover damages.
“If we buy insurance and never use it, that’s a good thing,” he said.
Over the next few years, the price outlook for cattle is not predicted to be as secure as it has been in recent years past. Some of these risk management tools may be useful to producers who want to mitigate some of their price risk.
“If we purchase an option or insurance on our calves in the spring, we won’t have quite that same pressure in the fall to just market as soon as we can. When the price starts to go down in the fall, we can wait for those rallies because we know, worst case, what we will get,” he described.
Feuz also added, “We have a little more market negotiation power to think about some of those upswings and working with the buyer.”