There are many risk management strategies that offer price protection for short hedgers involved in producing or selling livestock or livestock products, such as cattle ranchers, hog producers, feedlots, meat packers and exporters.
We have looked at risk management strategies for short hedgers that involve selling futures to lock in a selling price or buying put options to establish a minimum selling price.
At times, short hedgers are interested in a strategy that provides downside protection and the ability to take advantage of higher prices, but at less cost than simply buying a put option. One alternative is to buy a put option, and simultaneously sell a call option.
This module will describe how livestock sellers can simultaneously buy puts and sell calls. Not only will this allow the seller to establish a selling price range for his livestock, but the premium he receives from selling the call option helps to finance or reduce the cost of buying the put.
In an option strategy that establishes a selling price range, buying a put option will set the floor price and selling a call option will set the ceiling price. The ceiling and floor prices are determined by the strike prices of the option, so a hedger would choose a lower strike price for the put option he is buying, and a higher strike price for the call option that he is selling.
Assume that it is December and a hog producer is planning to sell his hogs 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.
The hog producer is comfortable that selling his hogs at the expected price of $60 will allow his operations to be profitable.
However, he decides to incorporate options into his hedging strategy to be able to take advantage of any upward price movement and, at the same time, ensure that the price he gets for his hogs will not drop beyond a specific level.
The hog producer has many different strike prices to choose from to establish his selling range. After considering the various strike prices, and considering his objectives and risk exposure, he decides to buy an at-the-money Lean Hog put option with a strike price of $65 for a premium of $5, and simultaneously sell an out-of-the-money Lean Hog call option with a strike price of $70 for a premium of $3.
This means that he will implement the strategy at a net premium cost of $2: the difference between the $5 premium he paid, and the $3 premium he received. The net premium is deducted from the calculations to determine the ceiling and floor prices.
With this strategy he can establish a floor price of $58 per hundredweight, which equals the put strike price of $65 minus the expected $5 basis minus the $2 net premium he paid.
And he also establishes a ceiling price of $63 per hundredweight, which equals the call strike price of $70 minus the expected $5 basis minus the $2 net premium he paid.
The hog producer now has a selling price range for his hogs of $58 to $63. This means that no matter what happens in the Lean Log futures market during the life of the option, his net selling price will be no lower than $58 per hundredweight and no higher than $63 per hundredweight, subject to any change in the basis.
If the Lean Hog futures price drops to $55, his net selling price will be $58 per hundredweight: the futures price of $55 minus the expected $5 basis plus $10, which is the difference between the put strike price and the futures price, minus the $2 net premium he paid.
On the other hand, if the Lean Hog futures price goes up to $75, his net selling price will be $63 per hundredweight: the futures price of $75 minus the expected $5 basis minus $5, which is the difference between the futures price and the call strike price, minus the $2 net premium he paid.
The selling price range, $5, is the difference between the two strike prices. The hog producer will choose his price range based on the risk tolerance of his business.
It is important to keep in mind that, as the seller of the call option side of the strategy, he will be required to post a performance bond upfront at the time that he sells them.
Now that the hog producer knows the minimum and maximum prices he will receive for his hogs, he can plan and make decisions for his operations with a higher level of confidence.
No one can predict the future, but hedgers can take steps to manage it. Using Livestock futures and options allows you to protect against falling prices with peace of mind, knowing you took steps to manage the risk involved in selling livestock and livestock products.