AgDM newsletter article, January 1997

Cattle pricing strategies

John LawrenceBy John Lawrence, Extension Livestock Economist and Director Iowa Beef Center, 515.294.6290, jdlaw@iastate.edu

Cattle feeders are faced with the decision to either lock-in a selling price in advance by hedging or wait and take the cash price when the cattle are marketed. Although there is no sure fire way of making this decision, the analysis below can help improve your odds.

The percentage of weeks that a futures contract price was higher than its expiration price is shown in Table 1. Thursday prices are used to present the weekly and expiration prices. For example, for the February 1980 contract, 71 percent of the 51 Thursday prices prior to expiration were higher than the Thursday price during expiration. The August 1980 contract had only 4 percent of weeks higher. Six contracts (February and December 1981, April 1985, April 1995, and February and April 1996) expired with 100 percent of the weeks higher than the expiration price. Conversely, 20 contracts expired at their high price (no weeks were higher than expiration).

Cyclical pattern

Note that there appears to be a cyclical pattern to futures prices. For 12 of the 13 contracts from the February1980 to February 1982 contract, the weekly prices were higher than the expiration price more than 60 percent of the time. For 15 of the 18 contracts from April 1982 through February 1985, the weekly prices were higher than expiration less than 40 percent of the time.

Similar patterns exist throughout the 17-year period. The patterns indicate that futures market participants (over a period of time) consistently underestimate or overestimate the expiration price. Then they change their perspective, overreact, and miss the market in the other direction.

Causes of cycles
Many of these patterns match fundamental factors in the cattle market. The 1985-86 period when contracts expired near their lows coincided with the bottom of the cattle price cycle in the 1980s. Fed cattle sold in the low $50 range both summers.

Cattle prices improved in the second half of 1986 and climbed until 1990 before prices leveled off. Cattle prices finally set a record high in the spring of 1993. During this period, contracts expired near their highs 80 percent of the time.

Prices have worked generally lower form March 1993 to April 1996. Except for February and October 1995, live cattle contracts from October 1993 through April 1996 have generally expired near their lows.

Current pattern
Although history is not a perfect predictor of the future, this simple analysis indicates that the futures market may have switched direction in June 1996 and is beginning to underestimate expiration prices. Following the 16-contract period (ending with April 1996) that weekly prices were consistently above the expiration price, the weekly prices have been consistently below the expiration price during the last four contracts.

The fundamentals suggest that beef supplies will continue large well into 1997, but they may not be as large as the futures market anticipates. As a result, traders may be overly bearish until late in the contract period.

Pricing strategy

Although cattle feeders should still consider price protection, this analysis suggests that other risk management strategies may work better than hedging with futures. Because futures prices may begin to trend higher toward expiration, it may be better to purchase a put option. Buying a put option gives you protection from prices lower than the strike price, but you can sell at higher prices if they rise.

Table 1. Percent of time (final 51 weeks) weekly futures prices were higher than expiration price.

Year

Feb.

Apr.

June

Aug.

Oct.

Dec.

1980

71%

92%

77%

4%

61%

73%

1981

100

88

61

69

86

100

1982

71

0

12

2

33

78

1983

8

2

12

35

28

0

1984

6

10

53

26

59

8

1985

26

100

98

94

67

41

1986

94

94

84

4

0

18

1987

0

0

0

0

0

22

1988

0

4

24

0

0

16

1989

6

14

84

2

14

0

1990

8

14

78

2

14

0

1991

0

14

33

98

45

98

1992

0

10

33

2

0

0

1993

0

4

10

10

75

57

1994

73

96

98

82

96

94

1995

14

100

84

73

0

84

1996

100

100

35

0

4

24

 

|Ag Decision Maker Home Page|