AgDM newsletter article, September 2000

Live cattle futures and options: How have they done? Part 1.

John LawrenceBy John Lawrence, extension livestock economist and director, Iowa Beef Center, 515-294-6290, jdlaw@iastate.edu

Futures markets have been available since the mid-1960s and option markets since the early 1980s. Although we still hold educational meetings on how they work, relatively few producers use these tools. Below is a brief discussion of risk management and efficient markets. In addition, I briefly describe a recent analysis of both futures and options and their effectiveness over the last decade.

Risk

Risk is defined as the chance of an unfavorable outcome. This simple definition means that we focus on the bad things that may or may not happen (lower selling prices, higher input prices, high mortality, or morbidity).

Generally, livestock price risk is far greater than production risk. In Midwestern feedlots, variation in the price of fed cattle, feeder cattle, and corn explained 74 percent of the variation in returns to feeding yearling steers compared with less than 10 percent due to variation in average daily gain and feed efficiency. Futures and options can address price risk.

Farmers in general and cattle feeders in particular perceive two types of risk:

Risk management

The challenge is to capture acceptable profits while keeping the businesses afloat. Thus, it is important to differentiate between risk management and price enhancement. Often futures and options are shunned because the average net price from using them is lower than the cash market price. The use of futures or options does not enhance the price. If they were used to reduce risk, then evaluate them on the basis of the size of losses or percent of time that losses occurred.

Efficient markets and low margins

Modern markets also are very efficient in that they quickly incorporate information and expectations of all market participants. Thus it is impossible to consistently outguess the markets. Likewise, because large-scale, professionally managed feedyards are willing to work on thin margins, it is difficult to hedge a price much above breakeven given the price of feeder cattle at the time. Profit seeking individuals will quickly bid any futures price increase into the price of feeder cattle. As a result, a common complaint of Iowa cattle feeders is that the futures market does not offer enough profit potential to make them worth using. Typically then, these cattle feeders take their chances in the cash market.

Historic perspective

If the cattle market is so efficient, is it possible to hedge a profit or are the Iowa cattle feeders right? The percentage of trading days during a six-month feeding period that the futures price, adjusted for a five year average basis, produced an expected hedge price that was equal to or better than the projected breakeven price for yearling feeders is shown in Table 1. Some years (reading across the rows) did not provide many opportunities for hedging a profit (i.e., 1991, 1996, and 1998). Other years such as 1993 and 1999 had several days when a breakeven or better price could be hedged. Also note that there are certain months (March and April) that generate a breakeven or better hedge price year after year. June, July, August, and December, however, have lower chances. As may be expected, these months tend to have the same results in the cash market. Spring months are more profitable than summer months.

Table 1. Percent of trading days during a six-month feeding period that a breakeven or better price could be hedged for yearlings.

 

Month Sold

Jan.

Feb.

Mar.

Apr.

May

June

July

Aug.

Sept.

Oct.

Nov.

Dec.

1990

74

40

100

100

39

3

0

40

51

44

2

1

1991

16

56

99

90

7

2

0

20

76

70

81

42

1992

0

92

98

97

37

77

28

95

98

98

98

0

1993

98

97

97

96

96

97

82

88

89

70

81

55

1994

58

17

96

97

88

64

47

33

30

34

98

98

1995

98

89

99

99

95

48

0

0

0

34

91

91

1996

98

83

71

50

30

0

14

21

49

89

85

88

1997

96

97

97

96

96

96

97

97

97

54

19

20

1998

41

20

48

41

98

9

57

58

38

23

24

43

1999

91

98

100

98

100

98

91

80

99

99

98

98

Avg.

67

69

90

86

69

49

42

53

63

61

68

54

The average percentage of trading days during the feeding period (reported by the month the cattle are sold) that a futures hedge produced a return above breakeven plus or minus an adjustment is shown in Table 2. For example, on average, a feedlot could hedge a price that was $4/cwt below breakeven 96 percent of the days during the feeding period ending in January. Reading down the column, it could hedge a breakeven 67 percent of the time, and a $4/cwt profit only 16 percent of the days for cattle sold in January.

Table 2 indicates that the possibility of hedging profits greater than $3/cwt are pretty rare, and that cattle sold in March and April are the only ones that had more than a 60 percent chance of hedging a profit greater than $1/cwt. The markets are efficient.

Table 2. Percent of trading days during a six-month feeding period that breakeven, plus or minus an adjustment factor, could be hedged for yearlings, 1990-1999.

BE *

Month sold

$/cwt.

Jan.

Feb.

Mar.

Apr.

May

June

July

Aug.

Sept.

Oct.

Nov.

Dec.

Avg.

-$4

96

95

96

97

93

81

79

85

90

92

96

86

90

-$3

93

94

96

95

90

72

70

77

85

88

94

81

86

-$2

88

88

94

92

83

66

58

70

76

82

87

70

80

-$1

77

80

92

90

76

57

49

63

70

73

78

63

72

$0

67

69

90

86

69

49

42

53

63

61

68

54

64

$1

59

53

84

80

59

44

30

39

55

45

56

40

54

$2

45

38

70

74

53

35

18

23

42

36

40

29

42

$3

32

25

58

65

48

26

13

11

29

28

29

21

32

$4

16

14

50

52

40

20

6

5

13

21

22

13

23

* Breakeven plus or minus the adjustment factor.

Does the absence of large guaranteed profits mean that futures and options have no value to cattle producers? No. It means that these are available tools that provide opportunities for cattle feeders to minimize losses, increase the probability of a positive return, or simply expand their operation by demonstrating to lenders their ability to generate a more predictable return.

 

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