Livestock Risk Management

The Livestock complex at CME Group was created in 1964 with the introduction of the Live Cattle futures contract, followed by Lean Hog futures in 1966 and Feeder Cattle futures in 1971. These contracts provide participants in the livestock industry with a means for hedging, the management of the price risks naturally inherent in the sale or purchase of livestock and meat products. 

Livestock Hedging

In hedging, price risk is transferred from those seeking to reduce it to others willing to assume it in hopes of making a profit.

Hedgers in the livestock markets include:

• Those who need protection against declining prices, such as hog farmers, cow/calf producers, feedlot operators and exporters
• Those looking for protection against rising prices, like feedlot operators purchasing young feeder cattle, meat packers and importers

Hedging is essentially taking a position in the futures or options market that is opposite one’s current position in the cash market. Since the cash and futures prices tend to move up and down together, any gains or losses in the cash market will be counterbalanced with gains or losses in the futures market.

Example

A cattle producer with weaned calves currently grazing, plans to sell to a feed lot once they reach the appropriate weight. In market terminology, he has a long cash position. In order to hedge and lock in a selling price, he would take a short position in the futures market, specifically Feeder Cattle futures, by selling futures contracts now and buying them back later when it is time to sell his herd in the cash market.

On the other hand, feed lot operators, meat packers and importers and others who expect to acquire livestock and meat products in the future have a short cash position. For instance, a meat packer expecting to purchase hogs for processing would be concerned about an increase in hog prices before he is ready to purchase the stock he needs. He would lock in a purchase price by taking a long position in the Lean Hog futures market. In other words, they would buy Lean Hog futures contracts now and sell them later when he is ready to purchase the hogs that he needs.

Knowing When to Buy or Sell

Here is a good hedging rule-of-thumb for determining whether to buy or sell Livestock futures:

• If your future action includes selling livestock in the cash market, an appropriate hedge today is selling futures
• If your future action includes buying livestock in the cash market, an appropriate hedge today is buying futures

Speculators facilitate hedging in the futures markets by taking the opposite side of most commercial trades. They are attracted to the market by the opportunity to realize a profit if they are correct in anticipating the direction and timing of Livestock price changes. In doing so, they provide market liquidity, which is the ability to enter and exit the market quickly, easily and efficiently.

A futures position is the most basic price risk management strategy for a livestock seller or buyer. Again, a short position allows the seller to lock in a sell price in advance of the actual sale, providing protection against falling prices and a long position lets a buyer lock in a purchase price and obtain protection against rising prices.

Options Strategies

If a livestock hedger would like protection against adverse price movements while benefitting from market moves, options provide protection and flexibility.

There are two basic options strategies that a livestock hedger could use.

1. A buyer could purchase a call option, which gives the owner of that option the right, but not the obligation, to buy Livestock futures at a specific price. A call option allows a buyer to establish a maximum or ceiling price for the animals he is buying, while still being able to take advantage of lower prices in the cash market should the opportunity arise.
2. A seller, on the other hand, would purchase a put option, which gives the owner of that option the right, but not the obligation, to sell Livestock futures at a specific price. A put option allows a livestock seller to establish a minimum or floor price for the stock or meat products he is selling, while still being able to take advantage of higher prices in the cash market, should the opportunity arise.

Summary

This module only scratches the surface of the wide array of strategies that can be incorporated into a livestock hedging program. No matter what a hedger’s concerns are, CME Group Livestock futures and options offer a variety of flexible choices to meet risk management needs.