Contract with the future: Hedging strategies help protect profit for cattle producers
October 3, 2018
We've all heard the seasoned cattleman joke, "Just do the opposite of what I'm doing, and you'll make money."
While in real life the modest guy or gal is usually the one to listen to and learn from, the principle of "doing the opposite" is the foundation of using the futures market to lock in commodity price protection.
The image of suits and ties or high heels, lots of yelling and hand signs in the pit at the Chicago Board of Trade is still very real. However, most commodity trading has evolved to a desk and computer screen and is highly speculated – not based on actual physical ownership of commodities. The world of trading is complex, technical and global. Fortunes can be made or lost at the sound of a bell. Still, the commodity market offers a platform to protect a paycheck – even to those whose trading experience may have peaked at backlot baseball cards.
Ag commodities are traded primarily on the Chicago Board of Trade (established in 1848 solely for ag commodities, now expanded and merged into the Chicago Mercantile Exchange Group). CBOT ag categories include dairy, fertilizer, grain and oilseeds, lumber, "softs," and livestock – of which there are only three categories: Lean Hogs, Feeder Cattle and Live Cattle (fats). Commodity trade is based on standardized contracts that specify quality and quantity. One contract of Feeder Cattle is equal to 50,000 pounds and traded out on eight months (skipping February, June, July and December). A Live Cattle contract is 40,000 and traded for February, April, June, August, October and December. Historically, selling a contract of a specified amount could result in delivery of that real, live commodity to a trading site. Rarely today does delivery actually take place, and trading is conducted almost exclusively on the board.
A variety of complex instruments and acronyms dot the landscape of the trading world, understood best by professional brokers and traders. However, in its most simplistic breakdown, commodity trading involves two kinds of actions: trades designed to protect a price in the market, known as hedging, and trades seeking to make a profit off the marketplace, known as speculating.
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There are two types of hedges: short hedges and long hedges. A short hedge protects against a price drop in a product you plan to sell in the future. A long hedge protects against a price increase in a product you plan to buy in the future.
The tools most commonly used in hedging are futures and options. Futures are purchasing the obligation to either buy or sell a specific commodity for a specific price at a specific date. Options are similar to futures, but, as implied, provide the option, not the obligation to buy or sell. If the board moves favorably, there is no requirement to offset with the purchased position.
An example of real-world hedging would be a cattle buyer who goes to the sale barn and buys approximately 50,000 pounds worth of cattle. He thinks he's going to sell them by March and wants to protect his profit. The March futures board is currently at $147.97. If the price drops below $140, he knows he'll lose money, so he chooses to protect his break-even. The price of a $144 position is $4, so he purchases a futures position for one contract of March Feeder Cattle. The $144 board less the $4 purchase protects his breakeven.
Other examples would be a cow-calf producer who plans to sell weaned calves in the fall, so he or she could buy a short hedge in the event the market tanks. A feedlot owner knows he has a 5,000-head capacity to fill, so he could buy a long hedge in an upward trending cattle market. That same feedlot owner sees the corn market creeping up, and could place a long hedge on corn.
Jon Prischmann owns BlueCreek Commodities & Hedging LLC in Fergus Falls, Minn., and works with a client base ranging from small farmers to large-capacity feedlots. He estimates about 70 percent of his customers are hedgers and 30 percent speculators, but often a combination of both.
"Using the futures market is really a tool," Prischmann said. "It's a tool that works a lot better in some markets than others, and you have to pick and choose when to use it to benefit your business."
Like any trading platform, profit-seeking speculators saturate the commodity market – many claim at the detriment of true cattle producers. In 2016 clamor arose to the point where the National Cattlemen's Beef Association and the CME formed a working group specifically to address volatility in the cattle market.
"There are big complaints out there about computer traders in New York and Chicago who never leave the high rise but sway the cattle market," said Prischmann, "and there is some truth to that, absolutely. These guys don't care if they're trading walnuts or coconuts or how hard [cattle producers] work – they are just making money off the misfortune of others."
Feeder Cattle futures tend to reflect the cash market with less instability from outside trading than the Live Cattle. However, the purpose of speculators in any market is to assume the price risk that hedgers are seeking to avoid. In the trading world, in order for someone to make money, someone else has to lose money.
"Fast computer trading certainly does affect the markets," said Prischmann. "Yet if we get away from the intended purpose of speculators – to absorb risk – what's the point of it? It's certainly hotly debated on both sides."
Another form of insurance
To most cattle producers who buy or sell futures it's another form of insurance – and often one that is encouraged or required by partnering ag lenders.
"These guys calling me are using hedging as a tool – in dangerous times in the market it's used to stay in business. In good times, it's used to lock in a profit," said Prischmann.
Like any form of insurance, hedging should be viewed as protection and a sunk cost.
"You don't buy fire insurance then cheer for your barn to burn down, and you don't buy price protection and cheer for your market to go down," he said.
Prischmann said his overall feedback from people who get involved in hedging is they are glad they did, and he enjoys educating cattle producers on the process.
"Many people feel they should know a lot about trading before they try it, and they don't, so they just ignore it and hope for better days," he said. "My job is to know this stuff. We talk about what numbers work and what ones don't – I'm not going to have you do something if it's not going to help you."
For producers interested in learning more about hedging, there are many Extension resources on commodity trading, and the CME Institute offers a variety of free, online courses.
Even with all its complexities, the long and short of trading is it simply adds another option.