Hedging Against Falling Live Cattle Prices using Live Cattle Futures

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Contents

Hedging Against Falling Live Cattle Prices using Live Cattle Futures

Live Cattle producers can hedge against falling live cattle price by taking up a position in the live cattle futures market.

Live Cattle producers can employ what is known as a short hedge to lock in a future selling price for an ongoing production of live cattle that is only ready for sale sometime in the future.

To implement the short hedge, live cattle producers sell (short) enough live cattle futures contracts in the futures market to cover the quantity of live cattle to be produced.

Live Cattle Futures Short Hedge Example

A feedlot operator has just entered into a contract to sell 4.00 million pounds of live cattle, to be delivered in 3 months’ time. The sale price is agreed by both parties to be based on the market price of live cattle on the day of delivery. At the time of signing the agreement, spot price for live cattle is USD 0.8445/lb while the price of live cattle futures for delivery in 3 months’ time is USD 0.8400/lb.

To lock in the selling price at USD 0.8400/lb, the feedlot operator can enter a short position in an appropriate number of CME Live Cattle futures contracts. With each CME Live Cattle futures contract covering 40,000 pounds of live cattle, the feedlot operator will be required to short 100 futures contracts.

The effect of putting in place the hedge should guarantee that the feedlot operator will be able to sell the 4.00 million pounds of live cattle at USD 0.8400/lb for a total amount of USD 3,360,000. Let’s see how this is achieved by looking at scenarios in which the price of live cattle makes a significant move either upwards or downwards by delivery date.

Scenario #1: Live Cattle Spot Price Fell by 10% to USD 0.7601/lb on Delivery Date

As per the sales contract, the feedlot operator will have to sell the live cattle at only USD 0.7601/lb, resulting in a net sales proceeds of USD 3,040,200.

By delivery date, the live cattle futures price will have converged with the live cattle spot price and will be equal to USD 0.7601/lb. As the short futures position was entered at USD 0.8400/lb, it will have gained USD 0.8400 – USD 0.7601 = USD 0.0800 per pound. With 100 contracts covering a total of 4000000 pounds, the total gain from the short futures position is USD 319,800

Together, the gain in the live cattle futures market and the amount realised from the sales contract will total USD 319,800 + USD 3,040,200 = USD 3,360,000. This amount is equivalent to selling 4.00 million pounds of live cattle at USD 0.8400/lb.

Scenario #2: Live Cattle Spot Price Rose by 10% to USD 0.9290/lb on Delivery Date

With the increase in live cattle price to USD 0.9290/lb, the live cattle producer will be able to sell the 4.00 million pounds of live cattle for a higher net sales proceeds of USD 3,715,800.

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However, as the short futures position was entered at a lower price of USD 0.8400/lb, it will have lost USD 0.9290 – USD 0.8400 = USD 0.0890 per pound. With 100 contracts covering a total of 4.00 million pounds of live cattle, the total loss from the short futures position is USD 355,800.

In the end, the higher sales proceeds is offset by the loss in the live cattle futures market, resulting in a net proceeds of USD 3,715,800 – USD 355,800 = USD 3,360,000. Again, this is the same amount that would be received by selling 4.00 million pounds of live cattle at USD 0.8400/lb.

Risk/Reward Tradeoff

As can be seen from the above examples, the downside of the short hedge is that the live cattle seller would have been better off without the hedge if the price of the commodity went up.

An alternative way of hedging against falling live cattle prices while still be able to benefit from a rise in live cattle price is to buy live cattle put options.

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Hedging Against Falling Feeder Cattle Prices using Feeder Cattle Futures

Feeder Cattle producers can hedge against falling feeder cattle price by taking up a position in the feeder cattle futures market.

Feeder Cattle producers can employ what is known as a short hedge to lock in a future selling price for an ongoing production of feeder cattle that is only ready for sale sometime in the future.

To implement the short hedge, feeder cattle producers sell (short) enough feeder cattle futures contracts in the futures market to cover the quantity of feeder cattle to be produced.

Feeder Cattle Futures Short Hedge Example

A feeder cattle producer has just entered into a contract to sell 5.00 million pounds of feeder cattle, to be delivered in 3 months’ time. The sale price is agreed by both parties to be based on the market price of feeder cattle on the day of delivery. At the time of signing the agreement, spot price for feeder cattle is USD 0.9520/lb while the price of feeder cattle futures for delivery in 3 months’ time is USD 0.9500/lb.

To lock in the selling price at USD 0.9500/lb, the feeder cattle producer can enter a short position in an appropriate number of CME Feeder Cattle futures contracts. With each CME Feeder Cattle futures contract covering 50,000 pounds of feeder cattle, the feeder cattle producer will be required to short 100 futures contracts.

The effect of putting in place the hedge should guarantee that the feeder cattle producer will be able to sell the 5.00 million pounds of feeder cattle at USD 0.9500/lb for a total amount of USD 4,750,000. Let’s see how this is achieved by looking at scenarios in which the price of feeder cattle makes a significant move either upwards or downwards by delivery date.

Scenario #1: Feeder Cattle Spot Price Fell by 10% to USD 0.8568/lb on Delivery Date

As per the sales contract, the feeder cattle producer will have to sell the feeder cattle at only USD 0.8568/lb, resulting in a net sales proceeds of USD 4,284,000.

By delivery date, the feeder cattle futures price will have converged with the feeder cattle spot price and will be equal to USD 0.8568/lb. As the short futures position was entered at USD 0.9500/lb, it will have gained USD 0.9500 – USD 0.8568 = USD 0.0932 per pound. With 100 contracts covering a total of 5000000 pounds, the total gain from the short futures position is USD 466,000

Together, the gain in the feeder cattle futures market and the amount realised from the sales contract will total USD 466,000 + USD 4,284,000 = USD 4,750,000. This amount is equivalent to selling 5.00 million pounds of feeder cattle at USD 0.9500/lb.

Scenario #2: Feeder Cattle Spot Price Rose by 10% to USD 1.0472/lb on Delivery Date

With the increase in feeder cattle price to USD 1.0472/lb, the feeder cattle producer will be able to sell the 5.00 million pounds of feeder cattle for a higher net sales proceeds of USD 5,236,000.

However, as the short futures position was entered at a lower price of USD 0.9500/lb, it will have lost USD 1.0472 – USD 0.9500 = USD 0.0972 per pound. With 100 contracts covering a total of 5.00 million pounds of feeder cattle, the total loss from the short futures position is USD 486,000.

In the end, the higher sales proceeds is offset by the loss in the feeder cattle futures market, resulting in a net proceeds of USD 5,236,000 – USD 486,000 = USD 4,750,000. Again, this is the same amount that would be received by selling 5.00 million pounds of feeder cattle at USD 0.9500/lb.

Risk/Reward Tradeoff

As can be seen from the above examples, the downside of the short hedge is that the feeder cattle seller would have been better off without the hedge if the price of the commodity went up.

An alternative way of hedging against falling feeder cattle prices while still be able to benefit from a rise in feeder cattle price is to buy feeder cattle put options.

Learn More About Feeder Cattle Futures & Options Trading

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Continue Reading.

Buying Straddles into Earnings

Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

What are Binary Options and How to Trade Them?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]

Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

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Livestock Hedging and Risk Management

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The Livestock complex at CME Group was created in 1964 with the introduction of the Live Cattle futures contract, followed by Lean Hog futures in 1966 and Feeder Cattle futures in 1971. These contracts provide participants in the livestock industry with a means for hedging, the management of the price risks naturally inherent in the sale or purchase of livestock and meat products.

Livestock Hedging

In hedging, price risk is transferred from those seeking to reduce it to others willing to assume it in hopes of making a profit.

Hedgers in the livestock markets include:

  • Those who need protection against declining prices, such as hog farmers, cow/calf producers, feedlot operators and exporters
  • Those looking for protection against rising prices, like feedlot operators purchasing young feeder cattle, meat packers and importers

Hedging is essentially taking a position in the futures or options market that is opposite one’s current position in the cash market. Since the cash and futures prices tend to move up and down together, any gains or losses in the cash market will be counterbalanced with gains or losses in the futures market.

Example

A cattle producer with weaned calves currently grazing, plans to sell to a feed lot once they reach the appropriate weight. In market terminology, he has a long cash position. In order to hedge and lock in a selling price, he would take a short position in the futures market, specifically Feeder Cattle futures, by selling futures contracts now and buying them back later when it is time to sell his herd in the cash market.

On the other hand, feed lot operators, meat packers and importers and others who expect to acquire livestock and meat products in the future have a short cash position. For instance, a meat packer expecting to purchase hogs for processing would be concerned about an increase in hog prices before he is ready to purchase the stock he needs. He would lock in a purchase price by taking a long position in the Lean Hog futures market. In other words, they would buy Lean Hog futures contracts now and sell them later when he is ready to purchase the hogs that he needs.

Knowing When to Buy or Sell

Here is a good hedging rule-of-thumb for determining whether to buy or sell Livestock futures:

  • If your future action includes selling livestock in the cash market, an appropriate hedge today is selling futures
  • If your future action includes buying livestock in the cash market, an appropriate hedge today is buying futures

Speculators facilitate hedging in the futures markets by taking the opposite side of most commercial trades. They are attracted to the market by the opportunity to realize a profit if they are correct in anticipating the direction and timing of Livestock price changes. In doing so, they provide market liquidity, which is the ability to enter and exit the market quickly, easily and efficiently.

A futures position is the most basic price risk management strategy for a livestock seller or buyer. Again, a short position allows the seller to lock in a sell price in advance of the actual sale, providing protection against falling prices and a long position lets a buyer lock in a purchase price and obtain protection against rising prices.

Options Strategies

If a livestock hedger would like protection against adverse price movements while benefitting from market moves, options provide protection and flexibility.

There are two basic options strategies that a livestock hedger could use.

  1. A buyer could purchase a call option, which gives the owner of that option the right, but not the obligation, to buy Livestock futures at a specific price. A call option allows a buyer to establish a maximum or ceiling price for the animals he is buying, while still being able to take advantage of lower prices in the cash market should the opportunity arise.
  2. A seller, on the other hand, would purchase a put option, which gives the owner of that option the right, but not the obligation, to sell Livestock futures at a specific price. A put option allows a livestock seller to establish a minimum or floor price for the stock or meat products he is selling, while still being able to take advantage of higher prices in the cash market, should the opportunity arise.

Summary

This module only scratches the surface of the wide array of strategies that can be incorporated into a livestock hedging program. No matter what a hedger’s concerns are, CME Group Livestock futures and options offer a variety of flexible choices to meet risk management needs.

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