Livestock operators do their best to mitigate risk as much as possible, but sometimes events out of their control can throw them for a loop. The past few years have done that: droughts in 2011 and 2012 caused cattle operators to manage lower production & reduced inventory, and greater ethanol production increased input costs as producers vied with the biofuel industry for corn.
Meanwhile, outbreaks of the porcine epidemic diarrhea virus in 2013 and 2014 struck hog producers hard. That led to sharp movements in prices for cattle and hogs – both up and down – and the need for prudent risk management. As recently as February 2015, data from CME Group showed Lean Hog volatility rising to a record of 42.5 percent, for example.
Futures markets have always been one way for producers to mitigate risk, but livestock options have seen a surge in volume and open interest in recent years as more producers seek to use these instruments to mitigate risk and save on performance bond costs to hedge production.
Livestock options have been around since the 80’s, but as knowledge and education around these tools have grown so have trading volumes. This coincides with electronic trading volumes increasing as well with advancements in technology. Front end electronic trading platforms such as CME Direct can now help facilitate multi-leg option spreads through a Request for Quote (RFQ) in a user friendly manner. 2014 total livestock options volume was up 309 percent compared to 2008 total volume. The 2015 year to date total through June is already 78 percent more than full year 2008.
Steve Meyer, vice president of pork analysis for Express Markets, and a long-time livestock economist, says because the recent events led more independent producers to become active using options in risk management.
“What makes options useful is producers have the right not the obligation to take action in the future,” Meyer says. “If you buy a put option, it puts a floor on the price, while a call is a lid on the price. You can buy call options to put an upper limit on the cost of feeders, and buy put options to put lower limits on the selling price of live cattle and hogs.”
Jordan Levi, portfolio manager at Arcadia Asset Management, a commercial cattle firm, says as the market became more volatile, his firm learned how to manage a physical operation using options versus straight futures.
Levi said they tend to usually buy puts when basis is wide. Buying a put helps to lock in a floor and unlike selling a futures contract, there is less margin requirement from the exchange to execute this simple strategy.
“It helps us manage the day-to-day cash flow requirements,” he says. “A straight purchase options strategy ultimately defines how much capital you need to put up to manage your risk. You can be a more effective manger of cash.”
Meyer says when buying a put or a call, the option value will change with the underlying futures, so the buyer won’t necessarily have to execute a futures trade to benefit.
“The benefit is the price of the option. That’s the beauty of it,” he says. A holder of an option can simply sell the option at the improved price to gain its advantage.”
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Saving on Margin
Options can be used to compliment cash-market positions, according to Chip Whalen vice president of education and research at CIH, a consulting firm that provides margin management services to agricultural producers. Margin efficiencies can be realized when option strategies are used in conjunction with physical contracts in synthetic combinations, he says
Strategies like call or put spreads, or covered call spreads are examples of positions that can complement physical contracts in the cash market for a limited cost and are margin efficient, Whalen says.
He gave a hypothetical call spread example. A producer sells hogs to the packer for December delivery at $64 per hundredweight, but he or she still thinks prices might rise. In the producer’s brokerage account, he or she could buy a $64 call and sell a $74 call for $3.50.
“After that sale, a producer could participate in another $10 of higher prices for a net cost of $3.50,” he explains. “Where the efficiency comes in is the creation of a position by using the cash market and use a combination of options that don’t have that maintenance margin requirement,” he says.
Ultimately, the trend towards options might benefit cattle producers the most. At Great Plains Cattle Feeders in Texas, a 30,000 head feed yard, options have become a key part of the risk management approach.
“We have a number of producers that feed cattle with us. Producers have no interest in just breaking even, they want the cattle to make money,” says Great Plains President Shelby Horn, “To give those guys some upside potential, we use options.”
Horn says options are a good way to price in a floor, while leaving some upside potential if values rise, even before traditional hedging programs begin.
“When we try to hedge calves on ranches, being able to use options gives us more flexibility in pricing calves,” he says. “A lot of time we don’t know what the weather will do. If we think we’re going to be in a drought, we’re a little skeptical in forward contracting calves and expect them to be a certain weight and ready by a certain delivery date. We use options to allow us to have some price-protection for calves on the ranch and we can do it a long way in advance.”