TOP FARMER WEEKLY PERSPECTIVE 10/28/2022 BY BRYAN DOHERTY
Time to Defend Cattle?
Cattle futures have surged higher in recent weeks, following the strength in cash prices. Demand, declining supplies, and technical buying have helped to propel futures contracts to new contract highs. While demand has been a contributor to higher prices, consumer buying is likely to decline in the face of high inflation and a high U.S. dollar. Producers should take action to ensure they protect against lower prices.
If forward contracting is available, consider contracting up to 50% of expected production between now and the first half of 2023. Consider purchasing puts on the remaining 50% in the appropriate month for delivery. An at-the-money-put is a level of put protection that matches the current futures price. If cattle are trading at $160 per hundredweight, an at-the-money put would have a $160 strike price. An example of an out-of-the-money put would be a $150 put (where futures are at $160). An at-the-money put will cost more than an out-of-the money put, however, it will provide a higher level of protection. If you decide to buy an out-of-the-money put, you will be buying less price floor, and you would spend less. The trade-off for stronger protection is more cost. There is not a right or wrong decision in purchasing puts; it is a matter of how much you want to spend to achieve an acceptable level of protection best suited for your operation.
A fence strategy is when you purchase a put and sell a call option. The put could be at the money or out of the money, depending on the level of protection you choose to buy. The sold call is out of the money. By selling an out-of-the-money call, you are leaving room for cattle futures to rally. The call, however, will act as a ceiling against higher prices above the level you sell. If you sell a $170 call, you are selling someone the right to own cattle at $170. If futures are above this level at the option expiration date, you will be exercised and assigned a short futures at $170. Understand that the fence strategy is a marginable position.
All three strategies (forward selling, buying a put, and buying a fence) have merit. Choose the strategy that best fits your risk tolerance and goals. Learn of the risks and rewards before entering into any position. Be fully prepared to pay for puts and to pay margin if entering the fence strategy. Volatility in commodities is high and markets are moving fast, especially in recent months. Bullish markets can look bearish in a matter of days. Being prepared and proactive can help shift risk and take advantage of opportunities.
Futures trading is not for everyone. The risk of loss in trading is substantial. Therefore, carefully consider whether such trading is suitable for you in light of your financial condition. Past performance is not necessarily indicative of future results.