Establishing a Buying Price Range for Livestock

There are many risk management strategies that offer price protection for long hedgers of livestock and livestock products, such as feedlot operators, meat packers, and importers.

We haved looked at strategies for long hedgers that involve buying Livestock futures to lock in a purchase price, buying Livestock call options to establish a maximum purchase price, or selling Livestock put options to lower the purchase price.

Buying a Call, Selling a Put

At times, long hedgers are interested in a strategy that provides upside protection and the ability to take advantage of lower prices, but at less cost than simply buying a call option. One alternative is to buy a call option, and simultaneously sell a put option.

This module will describe how livestock buyers can simultaneously purchase calls and sell puts. Not only will this allow the livestock buyer to establish a buying price range for the livestock or livestock products that he needs, but the premium he receives from selling the put option helps to finance, or reduce, the cost of buying the call.

In an option strategy to create a buying price range, purchasing a call option will set a ceiling price and selling a put option will set a floor price. The floor and ceiling prices are determined by the strike prices of the options: the hedger would choose a higher strike price for the call option he is buying, and a lower strike price for the put option he is selling.

EXAMPLE

Assume that it is early spring and a meat packer is looking to purchase cattle in July. The normal basis for his area in July is $5 under the August Live Cattle futures price, which is currently $105 per hundredweight.

The meat packer is comfortable that buying cattle at the expected price of $100, which will allow his operations to be profitable.

He decides to incorporate options into his hedging strategy to be able to take advantage of any downward price movement, and at the same time ensure that the price he pays for cattle will not rise above a specific level.

The meat packer has many different strike prices available to establish his buying range. After considering the various strike prices, and taking into account his company’s objectives and risk exposure, he decides to buy an at-the-money Live Cattle call option with a strike price of $105 for a premium of $5, and simultaneously sell an out-of-the-money put option with a strike price of $100 for a premium of $3.

This means that he will implement the strategy at a net premium cost of $2: the difference between the $5 premium he paid and the $3 premium he received. The net premium is added into the calculations to determine the ceiling and floor prices.

With this strategy he is able to establish a ceiling price of $102 per hundredweight, which equals the call strike price of $105 minus the expected $5 basis plus the $2 net premium he paid.

The trader has also established a floor price of $97 per hundredweight which equals the put strike price of $100 minus the expected $5 basis plus the $2 net premium he paid.

The meat packer now has a buying price range for his cattle of $97 to $102. This means that no matter what happens in the futures market during the life of the option, his net buying price will be no higher than $102 per hundredweight, and no lower than $97 per hundredweight, subject to any change in the basis.

If the futures price goes up to $115, his net buying price will be $102 per hundredweight: the futures price of $115 minus the expected $5 basis minus $10, which is the difference between the futures price and the call strike price plus the $2 net premium he paid.

If the futures price drops to $90, his net buying price will be $97 hundredweight: the futures price of $90 minus the expected $5 basis plus $10, which is the difference between the put strike price and the futures price plus the $2 net premium he paid

The buying price range, $5, is the difference between the two strike prices. The meat packer will choose his price range based on his company’s risk tolerance level.

It is important to keep in mind that, as the seller of the put option side of the strategy, the meat packer will be required to post a performance bond at the time that he sells them.

Summary

Now that the food manufacturer knows the minimum and maximum prices he will pay for wheat, his company can plan and make decisions for their operations with a higher level of confidence.

No one can predict the future, but hedgers can take steps to manage it. Using grain futures and options allows those who need protection against higher prices to have peace of mind knowing that they took steps to manage the risk involved in buying these commodities.