There are many risk management strategies available that offer price protection for long hedgers, those involved in buying livestock and livestock products. Feedlot operators, meat packers and importers understand the impact a price increase could have on their business. It is important they at least familiarize themselves with the various alternatives for mitigating this risk and protecting their bottom line.
Buying futures contracts allows long hedgers to lock in a purchase 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 long hedgers, who have calculated the purchase price that will allow their business to be profitable.
However, some hedgers would like the ability to establish a maximum purchase price for livestock, while still being able to take advantage of a potential decline in livestock prices. That is where options come in, offering price protection plus flexibility.
This lesson will describe how livestock buyers can purchase call options to establish a maximum, or ceiling, purchase price for livestock, while still maintaining the opportunity to buy at a lower price.
Assume it is early spring and a meat packer is looking to purchase Live Cattle in July. The normal basis for his area in July is $3 over the August Live Cattle futures price, which is currently $105 per hundredweight.
This would give him an expected purchase price of $108, which is the August futures price plus the expected basis. The packer has determined that a purchase price of $110 will allow his meat packing operations to be breakeven. So, the potential to buy at a lower price is attractive to him.
One choice is to lock in the purchase price of $108 with a long futures hedge by buying August futures at $105. However, the packer decides to use call options to establish a ceiling purchase price, and retain the opportunity to potentially purchase Live Cattle at a lower price. By purchasing the call option, he has the right, but not the obligation, to buy futures at the strike price of the option.
In April, an August at-the-money call option with a strike price of $105 costs $4. With this call option, he will establish a ceiling price of $112, which equals the call option strike price of $105 plus the $4 premium he paid plus the 3-over basis. If Live Cattle prices increase, and basis is stable, this is the maximum price he will pay.
Suppose the August Live Cattle futures price rises to $115, which would mean a cash price of $118: the futures price plus the expected 3-over basis.
Since the call option gives the packer the right to buy at $105, even though Live Cattle futures are at $115; the call option has a value of at least $10, the futures price minus the $105 strike price. Deducting the $4 premium gives the packer a net gain of $6 on his call option hedge.
The cash price of $118 minus the $6 gain provides the packer with an effective purchase price of $112 per hundredweight. No matter how high Live Cattle prices have risen by the time he makes his purchase in July, assuming the basis is stable, the most he needs to pay for Live Cattle is $112.
Suppose the August Live Cattle futures price declines below the $105 strike price. In this situation, the meat packer will still be able to take advantage of the lower price.
For example, if August futures decrease to $95 per hundredweight, considering the 3-over expected basis, the cash price in the packer’s area would be $98.
Since the $95 futures price is less than the $105 strike price of the call option, the packer allows the option to expire and buys his cattle in the cash market.
The most he will lose is the $4 premium he paid up-front. His net purchase price will be $102, which is the futures price of $95, plus the 3-over basis, plus the $4 premium.
With Live Cattle prices rising, the net purchase price of $112 was higher compared to the $108 the meat packer would have locked in with the long futures hedge, the difference, essentially, being the option premium.
The packer was quite willing to pay the premium, however, because it allowed him to secure protection from rising prices and, unlike the long futures hedge, still pay a lower price for Live Cattle in a falling market: $102 per hundredweight versus $108 with a futures hedge.
He will pay more in this scenario than the $98 had he not hedged at all; the difference, again, being the option premium. But, knowing that the price could just have easily have risen, he was willing to pay this cost to ensure a maximum purchase price for his cattle.
Keep in mind that the packer also has the possibility to sell his call option for any time value that it may still hold. Whatever he receives from selling the option would reduce his net purchase price even more.
To summarize the benefits of buying call options for the long hedger:
- He knows the cost of the option and the maximum loss up front the option premium
- He can establish a ceiling price for his purchases
- He still can take advantage of lower 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 rising prices to have peace of mind of knowing that they have taken steps to manage the risk involved in purchasing livestock and livestock products for their business.
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