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Featured Article

4 October 2021

Case study: Cost-effectively navigating livestock market volatility

By CME Group

CLIENT:

Livestock industry participants

CHALLENGE:

Navigating market volatility in an uncertain economy

SOLUTION:

Option spread strategies

Overview:

Since the onset of the COVID-19 pandemic, livestock industry participants have faced high volatility in lean hog markets, driven by supply chain disruptions, animal diseases, and uncertain demand.

With no clear end to the volatility generated by the changing economic landscape, livestock market participants look to reduce downside risk and protect potential profits on their lean hog exposure from  price moves in the most cost-efficient way possible.

Approach:

While an outright option strategy is one way to achieve viable, cost-effective risk management, an option spread strategy – an options position that involves buying or selling multiple strikes and/or expirations on the same commodity – can provide more flexibility, lower costs, reduce margin requirements, and still offer specific protection tailored to certain risk management characteristics. Specifically, a vertical put option spread strategy can be used to mitigate risk with a defined risk/reward profile.

A vertical put spread is an options strategy that involves buying a put at a certain price and simultaneously selling a second put at the same expiration but at a different strike price. This strategy allows the user to incorporate a defined level of downside protection while reducing the upfront cost of the strategy. The upside of this trade is limited at the strike price of the second leg, while the downside is limited by the strike price of the first leg. The put spread allows for coverage up to the short strike. If futures drop below the short strike, the put spread does not offset any losses in the cash market.

Figure 1: Vertical Put Spread Profit and Loss

Figure 1: Vertical Put Spread Profit and Loss

Example:

 It is early October 2021, and a hog producer plans to sell 2,000 hogs at some point in the next two months. With the expected market weight of each hog being about 280 pounds, we estimate the corresponding carcass weight to be 205 pounds, using a dressing percentage of 73%. The producer is concerned about potential hog price weakness but also would like to take advantage should prices rise further. In order to protect against downside price risk but also take advantage of higher prices, the producer implements a vertical put spread strategy. December Lean Hog futures are currently trading at 74.000 cents per pound, a price the producer would like to receive.

­­Date: Early October 2021
December Lean Hog Futures Price (cents per lb): 74.000
Physical Position:  2,000 hogs for a total carcass weight of 410,000 pounds
Spread Strategy: Vertical Put
     Leg 1: Buy 10 Puts @73.000¢ for $4.80 premium
     Leg 2: Sell 10 Puts @68.000¢ for $3.025 premium

In early October, the producer initiates a vertical put strategy using December Lean Hog options, which settle into the December Lean Hog futures contract. Because the producer’s spread strategy hedges against relative downside price movement, the producer chooses a nearly at-the-money strike price for the buy-side leg of the spread. The strike price for the sell-side leg of the spread represents the lower limit of the producer’s downside protection. In a vertical put spread, the greater the difference between the strike prices of the two legs, the greater range of protection the spread provides. The cost for a vertical put spread, as represented by the sum of the premiums paid for the buy-side leg and received for the sell-side leg increases as the range of protection provided by the spread grows. Here, the producer is paying $1.775 (paying $4.80 for the buy-side leg of the spread and receiving $3.025 for the sell-side leg) and will start to receive protection for prices below $73 with a maximum payout of $3.225 for prices $68 or lower. Executing only the buy-side leg of the spread would provide unlimited downside protection but at a higher cost than for a vertical put spread, where the sale of the second leg offsets some of the cost of the first leg.

In early December, the December Lean Hog futures contract is trading at 68.000. The 73-put (the first leg) that the producer bought is worth $5.00 per contract. Because the producer paid an initial premium of $4.80 for this option, the net profit on this leg would total $0.20. Also, at 68.000 December futures, the 68-put that the producer sold (the second leg) would be near expiration and only worth a few cents, creating a near $3.025 profit for the premium initially collected when the spread was implemented. The vertical put spread thus nets the producer a profit of $3.225 per contract.

Table 1: Vertical Put Profit per Contract at 68.000 Futures

Leg/Premium PnL to Bill
Buy 73-Put – Collect/(Pay) Premium $ (4.80)
Buy 73-Put – Worth at 68 Fut $  5.00
Sell 68-Put – Collect/(Pay) Premium $  3.025
Sell 68-Put – Worth at 68 Fut $  0.00
Net Total $  3.225

This profit on the spread would soften the producer’s losses in the physical market. The producer’s execution of a vertical put spread in this scenario provides protection of $12,900 of a $24,600 loss that the producer suffers in the physical market. 

Figure 2: Vertical Put Spread in Lean Hog Options

Figure 2: Vertical Put Spread in Lean Hog Options

Results:

During periods of heightened volatility, option premiums are driven higher. Using one part of an options spread strategy to fund the other, vertical put spreads offer downside coverage at more affordable premium costs vs. an outright put. The table below shows the difference between the cost of the vertical put spread relative to buying an outright 73-put for $4.80. An outright put fully covers all downside risk, while a put spread offers partial coverage up to the short strike of the spread.

Figure 3: Vertical Put and Outright Put

Figure 3: Vertical Put and Outright Put

Conclusion:

Our cautious hog producer can hedge his lean hog exposure cost effectively by using a vertical put spread to manage his downside price risk exposure.

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