Risk management 201: How futures work and determining risk levelsRisk management 201: How futures work and determining risk levels
In Risk management 101, we analyzed the various levels of risk associated with using risk management tools to help price your calves. In the second part of this series, let’s look at some examples of how it all works.
October 12, 2017
How do people from all over the world get together and project a price for cattle for a date that falls between the end of the month (or the next month a contract is available, known as the nearby contract) all the way out to almost a full year away? The futures market.
As complex as it sounds, the futures market is simply a free market working as it should. As information is made publicly available, traders use this information as they see fit to predict where the new price should be. If the information they have indicates the price is going to drop, they will sell a contract to someone who believes the market is going to go up. This is called taking a short position.
If the market follows their expectations and goes down, they will offset their position by buying back that contract at a lower price, hence the phrase "buy low, sell high." If the market actually goes up, they will lose money, while the person who took the other position makes money. People who take part in this without producing the commodity or without the intention of buying it are called speculators. For those who are producers or buyers, this practice is called hedging.
When dealing with futures, a margin account is set up and an initial balance is deposited in that account. You must maintain your margin balance in order to keep your position.
These initial margin requirements and maintenance levels can differ by brokers. In the example earlier, a trader speculated the market was going to go down and took a short position. Fortunately, they guessed the market's movement right; as the market falls, they get money deposited into their margin account.
However, if they speculated wrong and the market went up, for every $1 per cwt the contract goes up, $500 is taken out of their margin account. At the end of every day, our account is marked to market, meaning the CME will adjust our margin account based on what we made or lost that day. If the balance in that margin account gets too low, a margin call is made telling you a deposit needs to be made. This can become an issue for hedgers if they don't understand what's really happening.
An example of a short hedge to minimize market risk
Imagine we want to lock in a price like forward contracting would do, but we don't have a buyer. We let the futures market become our buyer.
Let's assume the basis is going to stay constant, we don't have brokerage fees, and it is the beginning of May. We plan to sell 62 feeder steers weighing 800 pounds, or one contract worth of feeder cattle. We know we want to sell these steers at the first of August. We've calculated our breakeven to be $134 per cwt.
Therefore, we are watching the August feeder contracts go above our breakeven. It just so happens the cash price for an 800-pound steer at our local sale barn on that day is $145 per cwt, but the August futures price is above our breakeven by $20 per cwt, so we decide to hedge and sell one August feeder cattle contract for $154 per cwt.
We deposit our initial balance into our account, say it's $4,000, into our margin account. Our maintenance margin is $3,000, so we'll have to keep the balance at that amount or above. Looking at Figure 1, we can see the market moved up to $160 per hundredweight within a few days of selling that contract.
By the end of the first week, we've already had to pay an extra $2,000 into our margin account just to keep at the maintenance level. This may feel like a bad decision, but when we look at what's happened on the cash market, the price of our cattle has gone up as well. So that $2,000 we paid into the margin account is going to come back to us when we sell the steers on the cash market.
As time moved forward, we can see from the figure that the market fell to $150 per cwt shortly after. As the market moved down, our margin account was credited the $3,000 we lost in the first run up, as well as an additional $2,000 as the market dropped below the price at which we sold.
That's more like what we're wanting, right? Not really. On the cash market, the value of your cattle has dropped as well.
As we fast forward to the beginning of August, the market moved back up, then down again, finally settling around $148 per cwt. No extra margin calls were needed, and we sell the steers for $139 per cwt--$148 per cwt from the futures minus $9 per cwt from the basis = $139 per cwt on the cash market.
As soon as we sell the cattle, we need to offset our hedging position. If we hold on to the position longer than we have the cattle, we become speculators. We get back the losses we took in the cash market from the gains we made in the futures market, but we also get back the balance in our margin account.
Reviewing what we have done, our initial cash market value was $145 per cwt. On May 1, we sold an August feeder cattle contract for $154 per cwt. On August 1, we sold the cattle on the cash market for $139 per cwt. Last, we offset our futures position by buying back an August feeder contract for $148 per cwt. The total value we get back is $145 per cwt--$154 + $139 - $148 = $145.
One thing that makes hedging a challenge is when you have to make multiple margin calls. This cuts into your available capital. Make sure you understand you will get the capital back in the end through the cash market price.
Brokerage fees are a cost we did not include in this example. These fees end up adding a cost of 10 to 20 cents per cwt to a feeder contract. We also assumed a constant basis. While this would be nice, the final basis is an uncertainty but not as volatile as the cash market.
Therefore, while we limited ourselves to any potential losses in a down market by hedging, we also limited ourselves to any potential gains in an up market. Is there an option that gives us the opportunity to prevent any losses but not prevent any extra gains? Yes, it's called just that: an option.
Medium risk: Put option
Options give you the choice but not the obligation of buying or selling the underlying contract. A "put" gives you the option to sell a contract. A "call" gives you the option to buy a contract. You can also buy or sell a put, and buy or sell a call.
Each of these has a purpose, but for now we will focus strictly on buying a put option for feeder cattle. A put is the best way to set a minimum expected price without limiting the potential income from the market going up.
When we buy a put, we pay a premium for a desired strike price. The strike price is the value at which we could be selling a contract should we exercise the option. To calculate the minimum expected price, you take the strike price less the basis and the price paid for the premium per cwt.
In our hedge example, we had a breakeven price of $134 per cwt. At the beginning of May, the futures market was at $154 per cwt. At this price, the premium for a $134 per cwt option was very low, due in part to the market being on the rise.
For a put, as the market rises, its value will move closer to $0. Since we only wanted to protect our breakeven, and maybe a little profit since the market is moving up, we are going to buy an August feeder cattle put option at a strike price of $150 per cwt.
The higher the strike price goes, the more expensive it will become. However, because our breakeven is $20 per cwt lower than where the underlying futures contract is, or at the money, we can buy a put that's a little above our breakeven. At this strike price, our premium is about $600, or $1.20 per cwt--$600 ÷ 500 cwts = $1.20 per cwt.
If it were at the money strike price, the premium would be closer to $1,500. The minimum expected value we should receive in this example is $139.80 per cwt--$150 - $1.20 - $9 = $139.80.
Within that first week of owning our option, the markets continued to climb. This led to our option losing value, but we haven't had to make any margin calls because we haven't taken a position in the market. As time moved on, the market went up as high as $161 per cwt, down to as low as $141 per cwt and everywhere in between.
When August 1 finally comes, the futures market is at $148 per cwt. We sell the steers on the cash market for $139 per cvwt; remember our -$9 per cwt basis.
Now, we have a couple of choices. Our put option has a value of almost $1,650. We could sell it back for that value and recover our $600 premium cost plus $1,050 extra. This adds a value of about $2 per cwt to our cattle--$1,050 / 500 cwts = $2.10 per cwt).
This works out because we sold the cattle on the cash market for $139 per cwt. We paid $1.20 per cwt for the premium on our put but were able to sell it back for $2.10 per cwt, giving us a total value for this strategy of $139.90 per cwt--$139 - $1.20 + $2.10 = $139.90.
The other choice is to exercise the option and sell a futures contract at $150 per cwt. If we do this, we would immediately buy the contract back at the current price of $148 per cwt. This $2 per cwt change allows us to make an additional $1,000. The $2 per cwt loss we took on the cash market was made back through exercising our put option.
The total value for this strategy would end up being $139.80 per cwt. This is because we sold the cattle for $139 per cwt, paid a premium of $1.20 per cwt and made $2 per cwt from exercising our option--$139 - $1.20 + $2 = $139.80.
If the futures price on August 1 had been $5 per cwt higher than our strike price ($155 per cwt), the value of our put option would have been around $200. Because we're closer to the end of the contract, there is less risk that it will move below our strike price.
We have a couple choices in this scenario. We can sell the put option back and recover some of our costs, about 40 cents per cwt. We could sell the cattle at $146 per cwt--$155 futures - $9 basis = $146 cash, less the premium of $1.20 per cwt plus the 40 cents per cwt for selling the option back, giving us a total value of $145.20 per cwt.
Our other choice is to simply not use the option and let it expire. This would return us a value of $144.80 per cwt--$146 - $1.20 = $144.80. If the futures price was even higher, the option would have been worth even less but our cattle would be worth that much more, which would have allowed us to capitalize on a higher market price without chancing a loss.
Consider the tradeoffs
While the option may sound like the best choice, each choice has a tradeoff compared to another. A hedge is the best choice if the market goes down but the worst choice if the market goes up. The cash market is the best choice if the market goes up but the worst if the market goes down. A put option is second best if the market goes down because of the premium cost but also the second best if the market goes up, again because of the premium cost.
Depending on your level of willingness to accept risk, one of these risk management tools could be useful to you. While these examples provide the general concepts of how they work, the way each affects your bottom line could be different depending on your situation.
So, before you call up a commodities broker and dive into the futures markets, sharpen your pencil or open a spreadsheet, and speak with everyone involved—the owner, the manager, your spouse and your banker, to make sure everyone understands the plan and how it moves.
Cattle market strategies
There are different ways to manage market risks when selling your cattle. These four strategies are discussed in this article.
Cash market – Selling your cattle on an open market (i.e., a livestock auction).
Forward contract – An agreement to deliver cattle that meet a specified number, weights and delivery date.
Short hedge – Selling a futures contract to minimize the risk of fluctuating market prices on the open market.
Put option – The opportunity, but not the obligation, to sell a futures contract at the set strike price.
Terms to know
Seller's breakeven price - The minimum price you can receive without taking a loss.
Futures market – Where contracts for future deliveries on commodities are bought and sold.
Broker fees – Commissions paid to the broker who acts as the agent when buying or selling futures contracts or options.
Margin account – An account to hold the funds required to have a position in the futures market.
Margin calls – Monies that must be sent to the broker firm to maintain a position in the futures market when the market moves against the held position.
Basis – Accounts for the deviation in the form, location and time aspect of the commodity from the contract specifications.
Strike price – The designated price level at which an option is traded.
Information from the CME Group about feeder cattle hedging with futures and options can be found in the Self-Study Guide to Hedging with Livestock Futures and Options document.
Bradley is an agricultural economics consultant with the Noble Research Institutre in Ardmore, Okla.
You May Also Like
The dollars and sense of sustainabilityFeb 18, 2023
Current Conditions for
New York, NY
Enter a zip code to see the weather conditions for a different location.