Risk management strategies for feeder cattle have tradeoffs

While cattle market fundamentals remain encouraging, the amount of volatility in the market is unreal. This has led to increased option premiums, which also has increased the cost of coverage through Livestock Risk Protection insurance.

For this reason, several questions have arisen about alternative risk management strategies that don't involve as much premium expense. To be clear, I am not writing this because I don't like LRP insurance or put options. Both are excellent tools and absolutely have their place in risk management programs.

While no risk management tool is perfect, LRP is a subsided insurance product that can be scaled to any size of operation. It provides downside price risk protection, while still allowing for upside gain.

But I also understand the importance of managing premium costs. So below are brief descriptions of a few other strategies that are worth consideration for those who are large enough to utilize them.

Cash Forward Contract

While not common in my area, cash forward contracts remain a good risk management tool for cattle producers that want to price cattle for future delivery. In doing so, they effectively eliminate price risk – no downside risk and no upside potential. However, buyers can be hesitant to contract cattle in advance during volatile times. And even if a forward contract can be secured, buyers may offer weaker basis due to that risk.

Straight Hedge (short futures)

An alternative to a forward contract is simply a short future's position. While a forward contract eliminates both market risk and basis risk, a short future's position leaves basis open until delivery of cattle and closure of the future's position. With any futures strategy, basis risk should not be ignored. Hedgers with short futures positions also are subject to margin calls as prices rise, so they must consider the potential for capital needs until the cattle are sold.

Fixed Basis Contract + Short futures

Some buyers could be more comfortable locking in basis than forward contracting in a volatile market. A basis contract does not set a specific price for cattle but rather sets the basis on those cattle with respect to a specific futures contract (for example: $6 per cwt under the August board). If at the same time, the producer took a short position on that same futures contract, the short futures position would lock in the futures price and the fixed basis contract would eliminate basis risk. In this case, they would be subject to margin calls on the short futures position and would have to deliver as specified in the basis contract.

Synthetic Put

A synthetic put involves taking a short futures position and buying an out-of-the-money call option. The short futures position provides immediate downside price protection, while the call option allows the producer to capitalize on price increases. The more premium that is spent on the call option (ie: closer to the money), the sooner the producer can benefit from rising prices. The short futures position is subject to margin calls, but the long call will limit this to some extent as it increases in value. A forward contract could substitute for the short futures position to provide the downside coverage.

Fence / Window (Buy Put and Sell Call)

This one has become more attractive as options have become more expensive. A price floor is set by purchasing a put option, but some of that premium is offset by selling an out-of-the-money call option. Selling the call option really sets a ceiling on net price as the producer loses on the short call as prices rise. The price floor and ceiling establish a "window" or range of potential net prices. There are an unlimited number of ways to do this, but I like the put to be closer to the money than the call. This typically means that some net premium will be paid, but also means there is more upside potential. A slight derivation of this would be to utilize LRP insurance in place of the put option to establish the price floor. While LRP does not offer the flexibility of a put option, the subsidy should make premium costs a bit lower, which would result in a lower net option cost or a higher price floor.

Risk management strategies involve deliberate trade-offs. Producers either pay premiums or limit upside potential in order to reduce downside price risk.

The goal of this article was to quickly walk through some price risk management strategies that involved lower premium expense. Because every farmer faces a different financial situation and has different risk preferences, risk management strategies will differ as well. However, all producers should understand the risks they face and consider ways to best manage those risks.

This article first appeared in Cattle Market Notes Weekly.

Source: Dr. Kenny H. Burdine, Extension Professor, University of Kentucky

More information on the best risk management strategies for your cattle operation can be found at the extension office by calling 270-765-4121, emailing [email protected] or stopping by the Extension Service office at 111 Opportunity Way, Elizabethtown.

Joe Paterson is a Hardin County Extension agent for agriculture. He can be reached by calling 270-765-4121, emailing [email protected] or stopping by the office at 111 Opportunity Way, Elizabethtown.