Livestock Marketing - Cash markets versus futures and options

Jay Parsons Author

11/20/2020 Added

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Livestock Marketing

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[00:00:03.030]Welcome to Livestock Marketing
[00:00:05.660]Cash Markets versus Futures and Options.
[00:00:08.100]My name is Jay Parsons.
[00:00:09.287]I'm a professor in farm and ranch management specialists
[00:00:12.602]in the Department of Agricultural Economics
[00:00:15.830]at the University of Nebraska Lincoln.
[00:00:19.545]In the last episode,
[00:00:21.120]I discussed the importance of having a marketing plan,
[00:00:24.640]and I mentioned that most producers
[00:00:26.670]do not have a written marketing plan.
[00:00:29.325]Matter of fact very few have a written marketing plan.
[00:00:32.810]About half producers, half of the producers
[00:00:35.091]claimed to have a marketing plan in their head
[00:00:37.291]and about half don't really have a marketing plan at all.
[00:00:42.982]We discussed the importance of having that
[00:00:45.537]and being able to cover your cost of production
[00:00:48.678]with that marketing plan.
[00:00:51.660]In this episode, we'd like to dig into some of the tools,
[00:00:54.242]specifically, some of the tools on the
[00:00:56.990]Chicago Mercantile Exchange that you can use
[00:00:59.414]to help implement that marketing plan
[00:01:02.073]and meet those goals and objectives.
[00:01:09.846]So it's important to understand what we mean
[00:01:12.297]when we say cash markets.
[00:01:14.254]Cash markets are those markets
[00:01:17.023]where the agricultural commodity is physically traded.
[00:01:22.240]So in cash markets,
[00:01:25.660]we often refer to those as local markets,
[00:01:27.772]or sometimes we call them spot markets.
[00:01:30.234]So these are livestock auction barns
[00:01:31.775]and more and more lately video auction sales
[00:01:36.330]where prices are determined very directly
[00:01:38.937]and completely on the spot.
[00:01:41.923]It also involves direct and on-farm sales to feedlots.
[00:01:45.865]Anytime that you're selling cattle
[00:01:47.917]and somebody is paying you for those cattle
[00:01:50.081]and taking delivery of them,
[00:01:52.976]it is determined to be a cash market
[00:01:55.455]if that price is determined on the spot at that time.
[00:02:03.074]So which of the following markets
[00:02:05.070]does your operation regularly use?
[00:02:07.460]I mentioned auction auction barns,
[00:02:09.890]video auctions and direct on farm,
[00:02:12.530]or perhaps a combination of those.
[00:02:14.431]This is a typical response I get
[00:02:17.310]from the audience in Nebraska
[00:02:18.560]when I go out and do extension.
[00:02:20.774]Usually about two thirds of people in the audience
[00:02:22.880]only use an auction barn to market their cattle.
[00:02:26.772]The other one-third is usually split between those that use
[00:02:30.229]exclusively a video auction to market to cattle
[00:02:33.145]and those that use a combination
[00:02:34.880]of that direct sales or on farms or
[00:02:38.746]sorry combination of the video auction and the auction barn.
[00:02:44.448]But that's a typical response I would get from an audience
[00:02:47.490]in Nebraska when I'm doing extension programs
[00:02:49.980]and I asked him this question.
[00:02:51.270]So most people are getting that live bidding auction price
[00:02:55.470]in the actual auction barn
[00:02:57.480]but there's other tools available
[00:02:58.997]to help you on this cash markets.
[00:03:02.535]So a cash Forward contract would go different
[00:03:05.537]than just a cash market price in the sense that
[00:03:08.933]this would set that cash price for delivery of the animals,
[00:03:13.850]but it'd be sometime in the future.
[00:03:14.841]So this does involve physical delivery of the cattle.
[00:03:20.970]It does involve a private relationship with a buyer
[00:03:24.968]for that seller to connect with.
[00:03:27.498]So it's usually written in some form,
[00:03:29.767]video auction sales are often termed cash forward contracts
[00:03:34.523]when the feature delivery is sometime out
[00:03:36.333]in the distant future versus within the next day or so.
[00:03:40.561]And same thing with direct and on-farm sales
[00:03:43.650]where you're selling to a feed lot
[00:03:44.970]but it's for say a month or two months down the road
[00:03:47.480]you've already agreed upon the price for those cattle.
[00:03:50.130]All of those that fall
[00:03:50.963]onto the realm of being a cash forward contract.
[00:03:56.758]Those are opposed to what we call the futures markets
[00:04:00.500]and a lot of people get confused
[00:04:01.980]when we start talking about futures and options
[00:04:03.860]in the futures market in general
[00:04:05.358]and think it involves a whole bunch of delivery of cattle.
[00:04:09.740]Futures markets were developed
[00:04:11.750]to standardized trading of commodities.
[00:04:13.606]So all of these futures market contracts
[00:04:17.059]have very standardized language in them
[00:04:19.512]in order to set the prices.
[00:04:21.341]So a futures contract for feeder cattle say in 2019
[00:04:26.570]looks just like a futures contract for feeder cattle
[00:04:29.092]back in 2015.
[00:04:31.134]Rarely does the physical delivery of the cattle
[00:04:34.430]actually take place between the buyers and sellers
[00:04:36.780]on a particular contract is generally trading paper
[00:04:39.474]where people sell a contract and they end up offsetting it
[00:04:43.009]by buying a contract
[00:04:45.420]which nets out to zero cattle delivered.
[00:04:47.550]So we've talk about that as trading paper.
[00:04:51.380]In the feeder cattle market
[00:04:53.130]it's all settled electronically these days
[00:04:55.410]there is no actual delivery of the feeder cattle
[00:04:57.980]as a result of that contract.
[00:05:00.140]Futures market prices do help determine
[00:05:03.448]your local cash price.
[00:05:05.096]The difference between that futures market price
[00:05:09.103]and your local cash price is what we call the basis value.
[00:05:12.200]Basis in general is just the difference between two numbers
[00:05:15.440]and I use that term
[00:05:17.160]when we start talking about cattle markets,
[00:05:19.570]we're generally talking about the basis between
[00:05:22.900]or the difference between what's happening
[00:05:25.080]on the Chicago Mercantile Exchange
[00:05:27.670]versus what's happening in the local pricing exchanges
[00:05:31.750]which is usually in a local auction market.
[00:05:36.014]So here's that relationship and math,
[00:05:38.290]the cash price locally equals a futures price
[00:05:40.828]plus the basis, or another way of saying that
[00:05:44.068]is the definition of a basis
[00:05:46.480]or simply the difference between the cash price
[00:05:50.095]and the futures price.
[00:05:51.589]Most often this basis is less than zero.
[00:05:53.400]That is that the futures price
[00:05:56.079]on the Chicago Mercantile Exchange
[00:05:57.969]that the cash price is referenced to
[00:05:59.929]than what you get in the local auction market
[00:06:03.297]and that's because the transportation costs and so on
[00:06:06.080]to get those to the bulk buyers of the commodity.
[00:06:10.770]So you usually have a regional difference there
[00:06:12.980]that plays into that.
[00:06:14.690]In Nebraska, though,
[00:06:15.780]especially when it comes to feeder cattle,
[00:06:17.243]we typically have a positive basis
[00:06:19.237]in that our local cash price in our auction markets
[00:06:22.240]are typically trading above the futures price
[00:06:25.590]that you will see on the Chicago Mercantile Exchange
[00:06:28.952]for equivalent feeder cattle.
[00:06:31.606]The reason for that is
[00:06:33.359]even though we have a lot of cow calf operators
[00:06:35.751]and a lot of calves being produced in the State in Nebraska,
[00:06:38.417]we have relatively a large number of cattle on feed,
[00:06:40.260]large feed lots of handle those
[00:06:43.216]and large processing facilities
[00:06:45.083]so we are a net importer of feeder cattle and fed cattle
[00:06:48.200]to meet the capacity that we actually have in the state
[00:06:52.210]for feeding cattle and for slaughtering cattle.
[00:06:55.460]So our local calves actually bring a premium
[00:06:58.870]above the futures price that you'll see
[00:07:01.160]on the board of trade.
[00:07:02.500]So our basis is actually positive here in Nebraska
[00:07:05.690]most of the time for feeder cattle.
[00:07:08.454]What are some factors influencing that basis though
[00:07:11.500]supply and demand, the seasonality of the livestock markets?
[00:07:15.620]The the basis will shrink when you have low supply
[00:07:18.087]of the feeder cattle into the market and the and the buyers
[00:07:22.178]of those cattle have demand for them.
[00:07:25.480]So feed lot inventories get low
[00:07:27.240]and they want to fill the feed lot
[00:07:28.600]and there's not a lot of cattle out there.
[00:07:31.850]You'll see that basis become more positive
[00:07:34.095]for the actual seller of the feeder cattle.
[00:07:37.560]On the other hand, when you have a lot of feeder cattle
[00:07:40.510]being supplied, say at weaning time in the fall,
[00:07:44.290]the feedlots they'll have demand up to a point
[00:07:46.550]but as they begin to fill up, you'll see that basis wide now
[00:07:50.582]for them in terms of being more favorable to the buyer
[00:07:53.830]and they'll pay less for those cattle.
[00:07:55.940]So basis is largely determined
[00:07:57.683]by that regional supply and demand factors
[00:08:00.863]and also it can be influenced by the actual
[00:08:06.206]quality of livestock to some sense,
[00:08:08.760]but we see that quality of livestock
[00:08:11.270]in the auction sale barn really tick up
[00:08:13.620]and make a difference there.
[00:08:16.091]So good run on good quality cattle in a local auction
[00:08:18.760]will make it appear on paper at least at that basis
[00:08:21.221]is a much more favorable to the seller of cattle
[00:08:25.000]in that region versus the futures market
[00:08:26.830]which of course is just a standardized contract.
[00:08:29.040]So the quality premiums and stuff that you might see
[00:08:33.210]for particular cattle aren't gonna be reflected
[00:08:35.590]in that futures contract like they would
[00:08:38.836]in the local sale barn.
[00:08:40.040]Also just the general competitive nature at the auction
[00:08:42.650]the number of buyers and sellers present
[00:08:45.000]can influence that local price
[00:08:46.667]and of course, that non paper influence the actual basis.
[00:08:51.925]so that cash price equals features price plus basis
[00:08:55.510]is a relationship
[00:08:56.760]so when you do a futures contract
[00:08:58.770]in the Chicago Mercantile Exchange
[00:09:01.075]you are locking in the futures price
[00:09:02.130]which is just one of these three components.
[00:09:05.110]And one are the two components that make up the cash price
[00:09:08.180]you receive in the local marketplace
[00:09:11.177]when you physically sell your cattle
[00:09:13.269]it does not control the basis.
[00:09:15.536]So CME exchange contracts do not affect the basis.
[00:09:20.029]They only come in to help lock in
[00:09:21.944]that futures contract price.
[00:09:24.510]Options contracts lock in a floor or a ceiling
[00:09:28.120]if you're a seller of an option, have the, a call option
[00:09:32.740]which is an option to sell a futures contract.
[00:09:35.089]So an options contract is simply the option
[00:09:38.640]to sell a futures contract so when you do that,
[00:09:41.770]it's called a put option and it sets in a floor
[00:09:45.122]for that futures price.
[00:09:47.230]LRP insurance contracts we'll talk about more detail
[00:09:49.917]in the next episode is like an options contract
[00:09:53.750]in that it locks in a floor on that futures price.
[00:09:57.120]When you see a cash forward contract or a video sale,
[00:10:00.470]it's used to lock in the full cash price.
[00:10:02.653]So it's locking in both the futures price
[00:10:05.620]and the expected basis.
[00:10:07.970]Some people use a basis contract.
[00:10:10.110]You'll hear that sometimes called
[00:10:11.300]a formula contract in the trade.
[00:10:14.847]That's used to lock in the basis by itself.
[00:10:17.080]So when somebody offers you a formula contract
[00:10:19.960]or talks about cattle being sold on formula,
[00:10:22.510]they usually means that's a blocked in a particular basis
[00:10:25.610]to a particular reference futures price.
[00:10:27.930]So somebody might, for example, lock in a sale of cattle
[00:10:30.880]at $5 above the October futures price.
[00:10:34.856]And at that point when the actual cattle
[00:10:38.119]are delivered in October,
[00:10:39.434]they'll look at debt futures price, they'll see what it is
[00:10:42.552]and the local buyer will pay you $5, 100 weight
[00:10:45.826]above what that futures price is on that particular day
[00:10:49.390]or whatever they use as a reference there.
[00:10:53.490]So that's some of the lingo that you see on there.
[00:10:54.759]Here's an example of the cattle futures contracts.
[00:10:57.255]The feeder cattle contract
[00:11:01.110]is in that seven to eight and a half 100 weight range
[00:11:06.991]for medium frame number one steers.
[00:11:10.373]And they're sold at 50,000 pound chunks.
[00:11:13.882]So one contract is for 50,000 pounds of steers
[00:11:18.600]that are expected to be in that 700 to 850 pound range.
[00:11:22.870]These contracts are traded from January through November.
[00:11:26.910]You can see here that if there's eight months of the year
[00:11:29.912]that you can sell or buy a feeder cattle futures contracts.
[00:11:34.751]The last business day of the of the month
[00:11:37.667]is considered where your, these are expiring.
[00:11:41.110]So if you sell a futures contract for October,
[00:11:44.240]that contract is settled on the last business day of October
[00:11:47.587]or whatever those contracts are trading at.
[00:11:52.060]Live or fed cattle contracts are in 40,000 pound increments
[00:11:56.240]and they're expected to be slaughter weight steers
[00:11:59.026]and they are expected to grade 55% choice
[00:12:02.163]or 45% select steer.
[00:12:03.960]So again,
[00:12:05.010]these are just standardized contract for pricing purposes.
[00:12:07.436]Those are traded in six different months
[00:12:10.335]that you see listed here from February to April,
[00:12:14.330]in the spring, and then June and August and in the summer,
[00:12:17.310]and then October December in the fall
[00:12:19.580]and into the next part of winter.
[00:12:22.800]So those are the months that those are traded in at again,
[00:12:25.510]those are slaughter weighed animals
[00:12:26.990]in 40,000 pounds per contract.
[00:12:30.666]So what are some of the futures lingo we see out there?
[00:12:34.730]People talk about offsetting a contract.
[00:12:36.850]That is simply canceling a futures position.
[00:12:40.350]You achieve this
[00:12:41.183]by entering into an equal, but opposite contract.
[00:12:44.566]So here's an example if you were to sell
[00:12:46.510]for October feeder cattle contracts in April.
[00:12:49.730]So April of the year, you look at the October contract
[00:12:52.670]because you're wanting to lock in that futures price
[00:12:55.259]for your October feeder cattle you sell four contracts okay.
[00:12:59.022]That would be 200,000 pounds of feeder cattle steers that is
[00:13:04.023]and that's 700 to 850 pound range
[00:13:05.879]but you're doing that in April.
[00:13:09.945]You would offset that or cancel that contract by buying
[00:13:14.330]for October feeder cattle contracts.
[00:13:16.708]Okay, so, and you're doing this before October 30th
[00:13:22.140]because on October 31st, the last day of that month
[00:13:25.224]this'll be automatically cash settled.
[00:13:28.828]So we'll look at some examples of this
[00:13:31.740]as we go through here.
[00:13:32.830]So if I were to sell one contract on February seven
[00:13:36.701]at 150.90 per 100 weight
[00:13:38.694]for a feeder cattle futures contract,
[00:13:41.983]that contract has a value of $75,450.
[00:13:47.070]So that's what somebody is gonna pay me for that contract
[00:13:50.320]when I sell it.
[00:13:51.460]Okay, don't get too excited yet
[00:13:53.100]because you gotta offset that
[00:13:55.710]but that's the $150.90 100 weight
[00:13:58.430]times the 50,000 pound contract.
[00:14:02.230]When you do this, you gotta do it through a broker.
[00:14:05.029]That broker is gonna charge you a commission
[00:14:07.310]for that round turn trade.
[00:14:09.562]That's usually relatively minor
[00:14:11.998]'cause they're doing literally hundreds of these trades
[00:14:14.490]in any given morning
[00:14:17.398]or maybe even a thousand or more in a day.
[00:14:20.206]So they're, they're getting their commission
[00:14:23.042]and their income really off of volume.
[00:14:25.892]So there'll be a minor charge for that commission.
[00:14:27.860]There's also the big thing with a futures contract
[00:14:30.250]as you need to have a deposit account on record
[00:14:34.628]to cover any potential shortage.
[00:14:36.724]This will vary depending upon your broker
[00:14:40.274]but that's usually somewhere in that $4,000 range.
[00:14:43.540]The reason for that is the CME
[00:14:46.226]requires you to have enough money in your margin account
[00:14:50.570]to cover the daily price limit change.
[00:14:53.690]So if markets move against you
[00:14:55.671]and you are losing money on your contract,
[00:14:58.396]they want you to have enough money in your account
[00:15:02.315]to cover the max you could lose in any one day
[00:15:04.804]on that contract.
[00:15:07.080]So at 3,375 which is what that was set at
[00:15:11.810]at the time that I,
[00:15:13.600]the most recent time that I checked on that
[00:15:16.123]and I think that's still true today
[00:15:17.490]that equates to about $6.75a a 100 weight
[00:15:20.670]that you have to have maintain in a margin account.
[00:15:23.284]So somebody would, your broker would ask you,
[00:15:27.340]they'll set that deposit that they require,
[00:15:29.610]it'll be somewhere higher than that 3375,
[00:15:32.840]so say that's $4,050.
[00:15:34.884]That cushion there
[00:15:36.180]of of approximately $700 is how much cushion you have
[00:15:40.010]before you drop below that maintenance margin
[00:15:42.690]and if you dropped below that maintenance margin
[00:15:44.780]at the end of the day, the broker calls you up
[00:15:47.320]and tells you you need to replenish your account
[00:15:49.500]back up to the $4,050 mark.
[00:15:52.169]So you're gonna have to deposit more money
[00:15:54.500]into your account.
[00:15:55.333]That's what we call a margin call.
[00:15:57.670]And that's what people don't like
[00:16:00.094]about trading futures contracts
[00:16:01.444]is they gotta keep money on deposit
[00:16:03.715]to cover the maximum amount they could lose in one day.
[00:16:05.940]And this is just for one contract.
[00:16:07.620]So you can imagine people that have tens and twenties
[00:16:11.083]number of contracts on trade at any one time,
[00:16:15.398]they can they end up with several thousand dollars
[00:16:18.350]in a margin account to cover that.
[00:16:20.296]Alright, so let's continue with that example
[00:16:23.161]and see how that would trade out.
[00:16:26.850]So if you blocked in a sales at 150.90
[00:16:29.766]and price ended up going down between and October
[00:16:32.604]to 144.30, you would offset that contract
[00:16:36.770]if you don't do it before then
[00:16:38.800]the board of trade will do it for you automatically
[00:16:41.560]and buy back a contract at that price.
[00:16:44.138]So if the end of October rolls around
[00:16:46.242]and you haven't offset this yet, it would offset it for you
[00:16:49.895]at the October price of 144.30.
[00:16:53.390]That means you actually made money on that, right?
[00:16:55.510]You sold at 150 90, you bought back at 144 30
[00:16:59.240]she made $6.60 per 100 weight on that round turn trade.
[00:17:03.920]Your commission will be that you owe the broker
[00:17:06.400]will be subtracted out of that and that's profit to you.
[00:17:09.941]But that profit is likely to be offset
[00:17:12.690]by lower prices that you receive in the cash market
[00:17:15.377]as the cash market re reacts to this lower national price.
[00:17:20.660]On the other hand, if the price goes up
[00:17:23.380]to 155, a 100 weight,
[00:17:25.716]you would again have to offset
[00:17:27.750]at whatever that ending price is
[00:17:29.126]if you don't do it along the way
[00:17:32.420]so that 155 that you buy back at represents a loss
[00:17:37.483]because you sold at 150.90, bought back at 125
[00:17:41.537]you lost $4.10 a 100 weight on the round turn trade,
[00:17:45.222]plus your commission.
[00:17:47.275]So you lose money on futures contract, but most likely
[00:17:52.141]you're have higher local cash prices
[00:17:55.330]in reaction to this higher price
[00:17:57.600]in the national marketplace.
[00:17:59.660]So it nets out roughly the same
[00:18:01.558]as long as your basis, doesn't change.
[00:18:03.651]If your basis stays exactly the same,
[00:18:07.120]you'll end up netting out what you expected to get here
[00:18:10.890]with his contract plus the basis in your local marketplace
[00:18:15.603]'cause they always end up offsetting each other
[00:18:18.725]at some point here, whether it goes up or down
[00:18:22.046]with losses or gains in the futures contract
[00:18:25.765]or the CME exchange.
[00:18:29.060]Put options or another,
[00:18:30.190]because people don't like those margin calls
[00:18:32.880]and because people don't like the idea of
[00:18:35.070]if markets go up it still gets offset
[00:18:37.758]and I don't get a benefit from that,
[00:18:39.890]a lot of people like put options.
[00:18:42.150]Put options are again traded through your broker
[00:18:44.830]on the CMA exchange.
[00:18:46.891]There's the right, but not the obligation
[00:18:48.973]to sell a particular futures contract at a specified price
[00:18:51.650]at any time during the life of the option.
[00:18:54.500]So this establishes a price floor in the future
[00:18:57.760]because it's not an obligation to sell that futures contract
[00:19:01.458]which means you don't have to offset it if prices go higher.
[00:19:05.298]So that's a nice little feature or the put options
[00:19:10.130]people like that 'cause they can participate in that upside.
[00:19:13.821]So options terminology, you have what we call a strike price
[00:19:17.340]which is the specified price
[00:19:18.748]at which the underlying futures contract may be sold.
[00:19:22.360]And that's the case for a put, if it is a call option
[00:19:26.154]it would be
[00:19:27.430]the price at which you can buy that futures contract.
[00:19:30.797]For the most part, unless you're a feeder,
[00:19:33.920]if you're looking to buy and cattle to your feed yard,
[00:19:37.044]you aren't necessarily using these options to buy cattle.
[00:19:41.961]So as a cow calf producer,
[00:19:43.749]you're most often using a put option here.
[00:19:48.010]The premium itself is what it costs you to get the option.
[00:19:50.098]You know that up front when you purchase it,
[00:19:53.250]there's two components to it one of them it's
[00:19:55.180]it is it's intrinsic value, which is the value
[00:19:57.700]if it were to expire immediately,
[00:20:00.660]and most often people buy put options
[00:20:03.140]that are not of value intrinsically.
[00:20:05.804]So they're looking to cover a portion
[00:20:08.040]of that expected price not more than that expected price.
[00:20:12.440]If you do cover more than that expected price,
[00:20:15.414]we call that an in the money put option,
[00:20:17.880]it has an intrinsic value then attached to it
[00:20:20.620]and that's gonna be reflected
[00:20:22.170]in the price you have to pay for it.
[00:20:24.740]Time value is the other component
[00:20:26.900]and that's the amount that the premium exceeds
[00:20:30.150]the options intrinsic value.
[00:20:32.060]So even though you might be buying something
[00:20:34.410]that doesn't have current value to it,
[00:20:36.640]what we might call an at the money put, right?
[00:20:39.170]So the price strike price matches the current expectations
[00:20:44.870]or the current price that contract's being traded at
[00:20:47.580]so no intrinsic value,
[00:20:48.510]you still gotta pay for that because there's a time
[00:20:51.900]between now and then that you can exercise it.
[00:20:54.633]A time value's gonna be reflected in that premium.
[00:21:00.460]Okay, so here's an example
[00:21:01.870]of that same October, 2020 feeder cattle contract
[00:21:05.100]trading on February 7th at 150.90,
[00:21:08.430]you might on that particular day that I looked at up,
[00:21:11.610]the put option contracts that were available that day,
[00:21:15.690]there was an at the money put at 150
[00:21:17.710]or relatively at the money put you out 90 cents
[00:21:21.063]a 100 weight.
[00:21:22.343]That premium was $6.82 more or less per 100 weight,
[00:21:26.471]$4 below that at 146
[00:21:29.300]you could have bought a put option at 5.075.
[00:21:33.520]It's a little over $5 and then at 142 you could have bought
[00:21:37.480]a put option at 3.775.
[00:21:40.630]So what does that mean?
[00:21:42.239]That means you would pay that price upfront
[00:21:44.479]that premium price upfront, and when it gives you the option
[00:21:47.830]between now and the end of October
[00:21:50.094]to sell a futures contract at those prices.
[00:21:52.320]So if prices were to fall,
[00:21:54.957]then those strike prices would put you in the money
[00:21:58.221]with the put option and it would gain intrinsic value.
[00:22:01.876]And you could cash in that intrinsic value at any time
[00:22:05.241]by basically exercising the put
[00:22:07.779]and then exercising the round turn trade
[00:22:11.123]on the board of trade with that futures contract
[00:22:14.470]that you purchase or that you sold.
[00:22:17.635]Okay, there is a commission
[00:22:19.500]attached to that round turn trade, but that's usually
[00:22:22.710]you know again you know that up front and they tell you that
[00:22:25.500]when you find out what the premium is to go with it
[00:22:29.020]to actually purchase these options through your broker.
[00:22:34.335]So here's one cashed out to give you an example
[00:22:36.406]using our previous numbers, we have a put option at 150,
[00:22:43.280]we paid 6.825 for that option set $3,412.50
[00:22:47.960]that we'd have to pay up front to purchase that put option
[00:22:51.082]which is the right to sell a futures contract at 150.
[00:22:55.750]It's a futures contract ends up at 144.30
[00:22:58.059]like we had in our early example.
[00:23:00.209]The intrinsic value of that put option is $5.70
[00:23:02.683]a 100 weight.
[00:23:05.120]So then we could go ahead and exercise that option,
[00:23:08.370]collect that $5.70 a 100 weight profit out of that
[00:23:11.077]round turn trade.
[00:23:13.113]If we subtract off what we paid for the put option,
[00:23:15.621]we actually ended up with a negative gain here,
[00:23:18.301]$1.125 per 100 weight.
[00:23:22.439]So slight, we didn't quite make up all of our premium
[00:23:27.364]that we paid out there
[00:23:28.650]and we still would have a little commission to pay
[00:23:31.100]on top of that so this one, even though we were
[00:23:34.560]able to protect some downside risk with this put option
[00:23:37.840]we actually lost money on it in the long run
[00:23:40.198]but the idea of buying it is as prices would go
[00:23:42.916]lower and lower and lower, that 570 would get
[00:23:45.813]higher and higher and higher and eventually it would offset.
[00:23:49.581]We don't have to go very far before it offsets
[00:23:52.190]dollar for dollar with our actual change in prices.
[00:23:57.910]So again, you're likely to receive a lower cash price
[00:24:01.879]in the local market
[00:24:02.827]as reaction to this lower market condition.
[00:24:06.480]On the upside, if the futures contract settles at 155,
[00:24:09.621]your option is worthless 'cause there's no reason to buy
[00:24:12.780]or sell a futures option at 150, if you gotta turn around
[00:24:15.020]and buy one at 155, so you would let it expire.
[00:24:17.956]You're out that $6.82 a 100 weight or $3,400
[00:24:25.040]that's upfront cost and it's gone
[00:24:27.930]but you hope gon offset that in your local market
[00:24:30.910]by getting a higher cash market price
[00:24:33.610]and reaction to these higher prices.
[00:24:35.911]So the nice thing about put options is upfront
[00:24:39.307]the max you can lose is what you pay for them that $3,412.50
[00:24:45.360]and if prices go haywire, this will compensate you
[00:24:49.584]dollar for dollar without far, it drops below that
[00:24:54.060]option price, that strike price that you have set
[00:24:57.080]and you'll be able to recoup
[00:24:58.380]some of those losses here in the CME exchange.
[00:25:01.070]If prices go higher, you just let it expire
[00:25:05.530]and hopefully benefit from it in the local cash market.
[00:25:10.225]So, which would you choose among these?
[00:25:12.420]When I offered these choices to people out,
[00:25:14.720]when I do programs,
[00:25:16.360]I typically see a few people
[00:25:18.100]that wanna buy that at the money put
[00:25:19.910]and pay that extra premium.
[00:25:21.640]Most people are over when a protected portion of that price
[00:25:25.232]so they wanna take a little bit of a discount on the premium
[00:25:27.570]and only protect a portion of that.
[00:25:29.850]Very seldom note, do they go very far below.
[00:25:32.400]So this is very typical if I offer choices like that out
[00:25:34.877]in the public that I'll see about a one in four,
[00:25:38.430]take it at the money and the rest take it
[00:25:40.610]slightly below that.
[00:25:44.130]The last thing I'll mention is a basis contract.
[00:25:46.153]This is what I mentioned is a formula pricing contract.
[00:25:48.830]When you hear that term, this is most commonly used
[00:25:52.440]with fed cattle, where a feed lot will contract
[00:25:55.000]with a processor and agree on a price that is
[00:25:59.380]x number of dollars above or below
[00:26:02.000]whatever that fed cattle contract is trading at
[00:26:04.510]on the board of trade.
[00:26:06.020]So it establishes that basis
[00:26:07.349]between the futures contract price
[00:26:10.600]and the cash sale transaction physically taking place
[00:26:13.573]between the seller and the buyer.
[00:26:22.260]So with that, I'll end there with this episode.
[00:26:25.310]And then next episode, we'll tackle LRP insurance
[00:26:29.635]with which works a lot like a put option.

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Livestock Marketing - Cash markets versus futures and options

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