Page 42 - MWC 3-10-2022s

PRICE RISK Much like hedging through The Midwest Cattleman · March 10, 2022 · P42
continued from page 41 the sale of a futures contract, insurance product is very sim- price gains, although the down-
reason, it is crucial that lend- basis must also be considered ilar to a put option. Consider side protection is not as solid as
ers be fully aware of the plans with an option strategy as the the option example from before with forward contracts or short
if this strategy is used. Produc- strike price is based on the fu- for a producer that planned to futures. Finally, LRP insurance
ers must also consider basis as tures market. sell 800 lb feeder steers in Au- offers the best opportunity to
the value of the cattle they sell An additional limitation of gust. Rather than purchasing scale price protection to small-
will not perfectly match futures both futures-based strategies an August put, that producer er quantities. While forward
prices. (sale of futures and purchas- could instead purchase LRP in- contracts could be written in
Options on futures contracts ing of options) is the 50,000 lb surance with a coverage level any size, they tend to be more
provide an opportunity to have CME© Feeder Cattle contract of $174 per cwt and an end- available for larger volumes.
some downside protection, but size. The vast majority of Ken- ing date sometime during the Risk management strate-
also keep the ability to capital- tucky cattle producers are not month of August. If the CME© gies are very much dependent
ize on rising prices. For exam- large enough to utilize futures Feeder Cattle Index was below on the risk preferences and
ple, if the August CME© feed- and options. Fortunately, Live- $174 on the ending date of the financial situation of the indi-
er cattle futures contract was stock Risk Protection (LRP) policy, they would be indemni- vidual. The purpose of this ar-
trading at $180 per cwt, the pro- insurance provides an oppor- fied for the difference on every ticle was largely to point out
ducer might buy a put option tunity to purchase an insur- lb they covered. They must still what is being offered by the
with a strike price of $174. The ance product very much like self-insure the decrease until market and review some price
put option gives the producer a put option, but that can be the index reaches $174, and risk management strategies
the right to sell August futures scaled for smaller operations. they must also understand that are available. While these
at $174, which means their Additionally, the subsidy on basis – the policy is indemni- markets certainly have the po-
option will increase in value LRP has been increased sub- fied based on the CME© Feeder tential to go higher, it is very
as the market falls. They will stantially over the last couple Cattle Index, rather than what likely that attractive pricing
pay a premium for this right, of years, which makes it much they sell their cattle for. opportunities will be available
which becomes an additional more attractive from a premi- Forward contracts are the for producers looking to estab-
cost. They must also self-insure um perspective. only strategy described that do lish some downside price risk
the first $6 per cwt drop in the LRP is an insurance product not involve basis risk, as an ac- protection this year. Price risk
market (the difference between that pays an indemnity if the tual price for the cattle can be management is not about try-
the futures price and the strike CME© Feeder Cattle Index is agreed upon. Potential margin ing to cherry-pick market highs
price on the put). If feeder cat- below a selected coverage level calls are an important consider- as it is sometimes presented.
tle prices continue to rise, the on the ending date of the insur- ation for producers that choose It is about strategically man-
producer can benefit by sell- ance policy. The CME© Feeder to use short futures positions. aging downside price risk and
ing their cattle on the stronger Cattle Index is used to cash set- Put options and LRP insur- should be part of every produc-
market and the only expense tle open CME© Feeder Cattle ance both have the advantage er’s marketing plan.
is what was paid in premium. contracts at expiration, so this of leaving potential for upside

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