Establishing a Floor Price by Buying Livestock Put Options
There are many risk management strategies available offering price protection for short hedgers, those involved in producing or selling livestock and livestock products. Cattle ranchers, hog producers, feedlots, meat packers and exporters understand the impact that a decline in prices could have on their business. It is important that they at least familiarize themselves with various alternatives for mitigating this risk and protecting their bottom line.
Selling futures contracts allows short hedgers to lock in a selling price for livestock, because a loss in the cash market is made up by a gain in the futures market, and vice versa. This strategy will completely satisfy the needs of many short hedgers, who calculate the selling price that will allow their business to be profitable.
However, some hedgers would like the ability to establish a minimum selling price for livestock, while still being able to take advantage of a potential increase in livestock prices. That is where options come in, offering price protection plus flexibility.
This lesson will describe how livestock sellers can purchase put options to establish a minimum, or floor, selling price, while still maintaining the opportunity to sell livestock at a higher price.
Assume it is December, a hog producer is planning to sell his hogs in early spring, and is concerned that hog prices may decline by the time he is ready to sell his herd in March. The normal basis for his area in March is $5 under the April Lean Hog futures price, which is currently $65 per hundredweight.
This would give him an expected selling price of $60, which is the April futures price minus the expected basis. The producer has determined that a selling price of $55 will allows his operations to break even, so the potential to earn a higher price is attractive to him.
One strategy is to lock in the selling price of $60 with a short futures hedge, by selling April futures at $65. However, the hog producer decides to use put options to establish a floor selling price, and retain the opportunity to potentially sell his hogs at a higher price. By purchasing the put option, he has the right, but not the obligation, to sell futures at the strike price of the option.
In December, an April at-the-money put option with a strike price of $65 costs $5. With this put option, he will establish a floor price of $55, which equals the put option strike price of $65 minus the expected 5-under basis minus the $5 premium he paid for the option. If Lean Hog prices fall and the basis is stable, this is the minimum price he will receive.
Suppose the April Lean Hog futures price falls to $55, which would mean a cash price of $50, the futures price minus the expected 5-under basis.
Since the put option gives the hog producer the right to sell at $65, even though Lean Hog futures are at $55, the put option has a value of at least $10: the $65 strike price minus the futures price. Deducting the $5 premium gives the producer a net gain of $5 on his put option hedge.
The cash price of $50, plus the $5 gain, provides the producer with an effective selling price of $55 per hundredweight. No matter how low Lean Hog prices fall by the time he sells his hogs in April, assuming the basis is stable, the lowest price he will receive is $55.
But suppose the April Lean Hog futures price rises above the $65 strike price? In this situation, the hog producer will still be able to participate in the upward price movement.
For example, if April futures increase to $80 per hundredweight, considering the 5-under expected basis, the cash price in the processor’s area would be $75.
Since the $80 futures price is higher than the $65 strike price of the put option, the hog producer allows the option to expire and sells his hogs in the cash market.
The most he will lose is the $5 premium he paid up-front. His net selling price will be $70, which is the futures price of $80 minus the 5-under basis minus the $5 premium.
With hog prices falling, the net selling price of $55 was lower compared to the $60 he would have locked in with the short futures hedge; the difference, essentially, being the option premium.
The hog producer was quite willing to pay the premium because it allowed him to secure protection from declining prices and, unlike the short futures hedge, still can sell at a higher price for his hogs in a rising market: $70 per hundredweight versus $60 with a futures hedge.
He will receive less for his hogs in this scenario than the $75 had he not hedged at all; the difference, again, being the option premium. But, knowing that the price could have easily declined, he was willing to pay this cost to ensure a minimum selling price for his hogs.
Keep in mind that the hog producer also has the possibility of selling his put option for any time value that it may still hold. Whatever he receives from selling the option would increase his net selling price even more.
To summarize the benefits of buying put options for the short hedger:
- He knows the cost of the option and the maximum loss up front: the option premium
- He can establish a floor price for his sales
- He still can take advantage of higher prices
No one can predict the future, but hedgers can take steps to manage it. Using livestock futures and options allows those who need protection against falling prices to have peace of mind of knowing that they took steps to manage the risk involved in producing and selling livestock and livestock products for their business.
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