Selling Futures for Protection Against Falling Prices
Those involved in producing or selling livestock and livestock products are aware of the risks they face from a potential decline in prices. Market participants, such as cattle ranchers, hog producers, feedlots, meat packers and exporters, who are concerned about the impact that a price decrease could have on their business, are constantly seeking ways to mitigate this risk and protect their bottom line.
Fortunately, due to the availability of CME Group Livestock futures and options, there are many strategies that sellers can employ. This module will discuss selling Livestock futures as a hedge against declining prices, including how changes in the basis could affect the outcome.
Say that the seller is a hog producer, it is April and he is expecting to sell his hogs in the fall. Due to uncertainty around supply and demand, the producer is concerned hog prices could decline before he is ready to sell in September. The basis in his area in September is typically $5 under the October Lean Hog futures price, which is currently trading at $65 per hundredweight.
The hog producer knows he will be profitable if he sells his hogs for $60, so he decides to hedge by selling, or going short, October Lean Hog futures.
By hedging with October Lean Hog futures, he locks in an expected selling price of $60 per hundredweight, which is the October futures price of $65 minus the expected basis of five under.
Look at what happens to his short futures hedge if hog prices do decline, or if they, in fact, increase.
Assume that in September, the October Lean Hog futures price declines to $60 and the basis is five under, as expected. This means that the cash price for hogs in October is $55, which is $5 lower than cash hog price the producer was anticipating in March.
However, the $5 gain he makes when he offsets his short futures position by buying October Lean Hog futures will give him a net selling price of $60 per hundredweight, which is the futures price of $60 minus the expected basis of five under plus the $5 gain on the futures position.
Note: this is $5 higher than the price of hogs in the cash market.
If Lean Hog prices increase instead, the producer will still receive $60 per hundredweight for his hogs.
Suppose the October Lean Hog futures price rises from $65 to $68. With the basis at five under, the producer would sell his hogs locally at $63 and simultaneously offset his futures position by buying October Lean Hog futures at $68.
Even though he could sell his hogs at a higher price in the cash market, the hog producer lost $3 on his futures position. This still equates to a net selling price of $60, which is the futures price of $68 minus the expected basis of five under, minus the $3 loss on the futures position.
In this scenario, where hedging with futures provided protection against falling prices but did not allow him to take advantage of a higher price, it appears on the surface that hedging was a losing proposition for the hog producer.
However, remember his original goal at the beginning of this process: to lock in a selling price of $60 per hundredweight for his hogs. By hedging with futures, he accomplished what he intended when making the decision to hedge. Relinquishing the chance to get a higher price in exchange for securing price protection, knowing that the price could just as easily have declined, is a trade-off that a short futures hedger is willing to make.
The hog producer’s actual sell price will be affected by what happens to the basis between the time he initiates the hedge and when he is ready to sell. Keep in mind that a short hedger will benefit from a strengthening basis, or a basis that becomes less negative or more positive.
A basis that is stronger than expected could increase a short hedger’s net selling price even in the face of a price decline. In the earlier scenario, Lean Hogs fell to $60. If the basis strengthens from five under to two under, for example, his net selling price would be $63, which is the October futures price of $60 minus the basis of two under plus the futures gain of $5.
However, if the basis weakens, becomes less positive or more negative, it could lower the producer’s final selling price. If the basis weakens from five under to six under, for example, the result would be a net selling price of $59: the October futures price of $60 minus the basis of six under plus the futures gain of $5.
No one can predict the future, but hedgers can take steps to manage it. Selling Livestock futures allows those who need protection against falling prices to have peace of mind knowing that they took steps to manage the risk involved in producing or selling livestock and livestock products for their operations.