Feuz Cattle & Beef Market Analysis
Buying Puts

Producers of fed cattle or feeder cattle can establish a minimum or "floor"  price by buying a Put Option.  The floor price that the Put offers is the Strike price of the option minus the premium costs plus or minus the expected basis.  (The floor price will vary somewhat due to basis).

This strategy is executed by buying a Put option.  A higher strike price, more insurance, will result in a larger premium cost and the longer the time until the option expires will also result in higher premiums.  If the underlying market increases the most a producer can lose is the premium.  So, purchasing a higher strike put at a higher premium will result in a lower net selling price if the market increases compared to purchasing a lower strike put at a lower cost.  However, if the market declines, the higher  strike put will result in a higher floor price.  A producer must weigh the premium costs against the level of price insurance to determine what option strike price to purchase.

When the cattle are sold in the cash market, you usually would sell the put option if it had any value.  If cattle prices have increased above the strike price it is likely that the option will have no value and you simply let it expire.  However, if prices have declined below the strike price, then it will have value. Selling this put for that value is why you have purchased the price insurance.  If the option expires before you are ready to sell the cattle, you can exercise the option and you then acquire a short
hedge position at the strike price.  Later, when you sell the cattle, you then liquidate the short hedge by buying the futures contract.

Advantages

  • Establish a minimum price but no maximum price
  • There are no margin calls
  • You can choose the level of price insurance (strike price) that is best for you

Disadvantages

  • Premium cost;  purchasing price insurance a long time in advance of sale can be expensive
  • Fed cattle options expire about 30 days prior to the futures contract expiration
Example

A producer has some yearling steers on feed.  He expects to sell the fed steers in January.  It is currently October and the producer is wanting to put a price floor under the steers.  In Oct the producer buys a $80.00/cwt. Feb Put Option for $2.50/cwt. The expected local basis for January is -$1.00/cwt.  The expected minimum price is the strike price minus the premium, plus/minus the basis.  In this example that is $76.50/cwt.  The net realized price for two different market situations is presented below:
 
Market Strengthens
Date
Cash
Options
Basis
October
Expected Minimum Selling
Price = $76.50
Buy $80 FEB LC Put
for $2.50/cwt
Expected
   -$1.00
January
Sell Steers
for $86.00
FEB LC @ $87
Option Expires with $0 value
Actual
   -$1.00


Lose $2.50/cwt

Net Realized Price=Cash Price +/- Gain/Loss in Options = $86.00 - $2.50 = $83.50
Market Weakens
Date
Cash
Options
Basis
October
Expected Minimum Selling
Price = $76.50
Buy $80 FEB LC Put
for $2.50/cwt
Expected
   -$1.00
January
Sell Steers
for $70.00
FEB LC @ $71
Sell Option for $9.00
Actual
   -$1.00


Gain $6.50/cwt

Net Realized Price=Cash Price +/- Gain/Loss in Options = $70.00 + $6.50 = $76.50
Return to Hedging Alternatives
 
Description of a Fence
Description of a Short Hedge