Livestock Options Market
Options are often referred to as price insurance. The concept and terminology are similar to insurance you might buy on your house.
With an option, a floor or ceiling price can be established without locking in a price. The option holder can still benefit from favorable price changes in the market. Like insurance, you are protected from an unfavorable event if it occurs. The discussion below focuses on lean hog options, but the concepts apply to other livestock.
For hog producers, hog options set a minimum selling price on hogs. And on the input side, corn options can be used to set a maximum price for purchased corn.
What is a lean hog option?
A live hog option is the right to buy or sell a lean hog futures contract at a specified price within a given time period. A put option is the right to sell a futures contract and a call option is the right to buy a futures contract. As option buyer you have the right to buy or sell but there is no obligation to do so. It’s important to recognize that lean hog options are in underlying lean hog futures contracts, rather than the physical commodity.
The put option market and the call option market are separate markets. They are not opposite sides of the same market. So you can buy or sell puts and you can buy or sell calls. The seller of an option (either put or call) is an option writer. As a hog producer, you are most likely to be an option buyer, but in some situations you might also consider selling (writing) an option.
Options are traded on strike prices. Strike prices are the level of coverage you buy. For hog options there is a $2 per cwt. interval between strike prices and a $1 interval on the nearby contract. For example, options might be offered on June lean hogs at strike prices ranging from $74 to $86 per cwt., when the June hog contract is trading at $80 per cwt.
Like insurance, the cost of buying an option is the premium. This is paid up-front and is the cost of the option transaction - except for commission costs. It is also the maximum loss that an option buyer can experience. There are no margin deposits or margin calls for buying an option - unless an option is exercised and a futures contract is bought or sold.
The exposure for an option writer (or seller) is quite different than for an option buyer. The option writer receives the premium paid by the buyer in the initial transaction (similar to insurance). But, since the option writer is guaranteeing the option buyer the right to buy or sell a futures contract at a specified price, the loss potential is unlimited. As a result, margin deposits are required for writers of options.
The premium value for a specific hog option is determined in the options market by the interaction of buyers and sellers. It will be influenced primarily by three factors: the strike price in relation to the price of the underlying futures contract, the volatility of the market, and the time remaining before the option expires. A thorough discussion of options premiums is given in Information File Grain Price Options Basics.
Table 1 shows strike prices and premiums for put and call options for a hog futures contract.
You can buy a $76 strike price put option at a cost of $1.30 per cwt. for a total cost of $520 on a 40,000 lb. contract (400 cwt. x $1.30). You can buy an $80 strike price put option for $3.40. If you exercised the $80 put option, it will place you in the futures market, selling futures for $80. Then you can offset your position by buying futures at the current market price of $78 for a $2 gain.
You can buy a $76 strike price call option for $3.35. If you exercise the option it will place you in the futures market, buying futures for $76. Then you can offset your position by selling futures at the current market price of $78 for a gain of $2.
In both examples, the premium is greater than the current value of the option ($3.40 or $3.35 vs. $2). The difference is “time value” to reflect the risk of price changes between now and expiration. Time value will decline as the contract approaches the expiration date.
Choices in completing an option trade
Once you have taken a hog options position, three choices or alternatives are available to you. You can exercise the option if it appears to be advantageous, you can let the option expire, or you can offset the option with an opposite position in the option market. For example, if you bought a put option, you can re-sell the put.
Exercising the option means establishing a futures market position at the strike price specified by the option. You would consider doing this if price movements in the market had made this a profitable choice. And you could do this any time before the expiration date of the option. Hog options expire on the last trading day of the delivery month of the underlying futures contract.
You might, however, choose to sell (offset) the option instead. The option proceeds are usually greater if you re-sell (offset your position) rather than exercise the option. Also, selling the option would avoid the costs of being in the futures market (commission charges and margin costs).
The other alternative, letting the option expire, would be the logical choice if the option had lost all of its value because the market price was higher than the strike price.
Some ways to use options
Below are four ways that options can be used in a marketing plan.
Place a floor on selling prices
The most common way for a hog producer to use options would be to place a floor on the price of hogs to be marketed in the future. You could do this by purchasing a put option for the appropriate contract month.
The strike price selected will be influenced by the level of price protection desired. It might be a level that would cover variable costs, total costs, or some specified profit above all costs. The premium cost in relation to the price protection received or desired should also be considered.
An option strike price must be adjusted for the premium, commission cost, and an estimate of the basis to obtain an estimate of the net cash price floor or ceiling that is set.
For example, assume a June hog put option at a strike price of $78 has a premium of $2.30 per cwt.
The expected basis for the June futures contract is -$2.50 per cwt. and the commission cost for the options transaction is 10 cents per cwt. ($40 per contract). In this case, the $78 strike price would indicate a net price floor of about $73.10 as shown in Example 1. The only uncertainty is in the basis estimate. If actual basis turns out to be different than estimated, the net price floor will be different.
By using options this way, you can set a minimum price but leave the upside price potential open if prices rise. The option would be exercised or re-sold if the futures price drops below the strike price level. A minimum price is established because, if prices decline, the gain on the option offsets the decline in the cash price. You would let it expire if the cash price stayed above the minimum.
Hedge a hedge (synthetic put)
This option strategy combines an option position with a forward pricing strategy such as a cash contract or futures hedge. You would establish an approximate selling price with a hedge or a cash forward contract. The companion step would be to buy a call option granting the right to buy hog futures at the strike price. If the market goes up, the premium value of the call option will rise and can be sold at a profit. If the market goes down, the value of the call option will drop and it will be left to expire. In this way, the hedge or cash contract provides floor price protection. But you can benefit from a rising market through the gain in premium value of the call option. (See Example 2.)
This strategy can be used as an alternative to simply buying a put option if put premiums are too costly or not trading at the desired strike price.
Establishing a floating price
In this strategy, an initial price floor is set by buying a put option. If the price does not go up, you remain with that option position. If the price does go up, you sell the initial put option (at a loss) and buy another put at a higher strike price. Consider using this procedure if the loss from the put option sale is less than the initial additional cost of the higher strike price.
This strategy is designed to set both lower and upper price limits (to set a range of possible net prices). This is done by purchasing a put option (probably at a strike price below the current futures price) to set a price floor. Also, you sell (write) a call option to set a ceiling price (at a strike price above the current futures price). Overall exposure to risk will be reduced and a range of possible prices will be set as shown in Example 3. The income from the call premium will at least partially offset the cost of the put premium. If the market goes up, there will be margin calls on the call option, but the increased value of the cash commodity will offset the margin calls. If the price declines, the premium value of the put option will increase and offset the decline in the cash price.