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Defensive strategy for cattle futures

10/28/2011 @ 9:26am

Cattle futures are in a longterm uptrend, with prices recently topping just under $130 on April futures. On Friday, October 21, the USDA released its monthly Cattle on Feed Report. The placement (cattle placed in feedlots) figure was 105% of the previous year’s figure. This would imply there could be a back-log of cattle headed to the marketplace during the winter months, most likely around April. A defensive posture is warranted. Conditions currently provide an opportunity for producers wanting to protect high prices for live cattle. 

We will address two strategies. The first is purchasing a put option. Currently, $126 puts are priced near $4 per hundredweight. By purchasing this put, you pay $4 up front, establishing a futures floor of $126, less the $4 for premium, commission and fees. Therefore, your price floor is somewhere near $122. This is a good safety valve; lowering prices while leaving the topside for future price advance wide open. Buying a put could be viewed as buying an insurance policy against a futures price decline. 

A second strategy is called a fence. This is where you purchase a put and sell a call option. For example purposes, you purchase a $126 put for $4 and, at the same time, sell a $138 call option for $2. You are attempting to reduce the cost of the put. Over time, futures prices will either go up, down, or sideways. If prices stay under $138 by expiration, you will collect the full $2 premium and, therefore, offset the cost of your $126 put by $2. At expiration, your net out-of-pocket expense for the fence is $4, less $2, minus commission and fees. You have effectively raised your price floor. The “penalty” for building a higher price floor with a fence strategy is that you cap upside price potential. If cattle futures move above $138, at option expiration, you will be assigned a short futures at $138. If you can live with a hedge at a higher level, then this is a great strategy to implement. One downside of a fence strategy is that you are subject to margin call. You will need to make sure you have enough cash flow to meet margin requirements as the price of the sold call increases in value. 

As with any strategy, you should be fully aware of all the pros and cons, as well as cost, risk and margin requirements. Communicate with someone who is intricately familiar with these strategies and can help you become comfortable before making a decision. As a producer, using no strategy may work well as long as the trend is higher. However, that could end up being a poor strategy should prices come under selling pressure, and the trend changes. Often by the time you recognize a change in price trend, it is too late to implement strategy. We encourage you to stay open to ideas that could protect your bottom line.

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