Hedging Using Futures - Price Protection for Cattle Producers
Hedging with futures is one of the marketing tools that can be used to forward price a commodity to protect against a price movement. This article reviews the basics of hedging using a Chicago Mercantile Exchange (CME) live cattle futures contract as a short hedge (selling) for protection against a potential price decline. This discussion only considers the hedging of cattle and not the value of the Canadian dollar versus the American dollar.
A good starting point is to become familiar with some of the common futures trading terms.
The OMAFRA factsheet, "Managing Commodity Price Risk Using Hedging and Options" provides further explanations.
What is a futures contract?A futures contract is a standardized agreement that states the commodity, quantity, quality, expiry date and whether it is deliverable or cash settled. Futures contracts are traded (sold and purchased) on regulated exchanges (i.e. CME) to establish a price.
A CME live cattle contract is for 40,000 pounds. Therefore the number of head it represents will depend on the live market weight of cattle. For example, for cattle marketed at 1,450 pounds a futures contract would represent approximately 27 head. Contracts are available for the months of February, April, June, August, October, and December. They expire the last business day of the contract month. For example, the December 2011 live cattle contract will expire on December 30, 2011. Live cattle futures contracts are deliverable upon expiry. To remove the obligation to make or take delivery of cattle, the futures contract needs to be offset prior to expiry. In fact, very few futures contracts are delivered upon, they are offset. Generally, the trading in futures contracts is not for the exchange of the physical commodity, but rather it is the trading of obligations. Complete contract specifications for live cattle (and other futures contracts) are provided on the CME Group website (www.cmegroup.com).
Who trades futures contracts?
There are basically two types of traders who participate in the futures market, hedgers and speculators. Hedgers produce or use (i.e. farmers and packers) the physical commodity (i.e. live cattle) and trade futures with the goal to reduce price risk or establish prices for a commodity. Speculators generally do not trade or use the physical commodity. They trade futures to profit from the price movement in the futures market. Remember, for every seller there is a buyer and for every buyer there is a seller.
There are two types of hedgers, a short hedger who wants to protect against a price decline and a long hedger who wants to protect against a price rise. An example of a short hedger would be a cattle producer finishing cattle who wants to protect a future price against a potential decline. To start the hedge they would sell a live cattle futures contract. An example of a long hedger would be a cattle producer who needs corn for feed and who wants to protect a future corn price against a potential increase. To start the hedge he would buy a corn futures contract.
What is hedging with futures?
To hedge is to take a futures position that is equal and opposite to a position held in the cash market. The objective is to manage the risk of an adverse move in prices. Hedging works because futures and cash prices both respond to the underlying forces of supply and demand. This means they both tend to move together and in the same direction over time. Also, the futures contract delivery provision (or threat of delivery) helps to ensure the futures and cash prices eventually move together.
Example of a cattle short hedge
A short hedge provides protection against declining prices. If prices had gone up in the above example, the value realized from the futures hedge would have declined but the cash price should have increased since the two prices generally move in the same direction over time (not necessarily the same amount). The difference between the local cash price and the futures price is the basis.
What is the basis?
What is margin?
Futures trading is conducted using a margin account. When a futures trader enters into a futures position they are required to post an initial margin amount as specified by the futures exchange.
In summary, hedging with futures is one of the marketing tools that can used to forward price a commodity to protect against a movement in the price. Basically, you use a futures contract as a temporary substitute for an intended transaction in the cash market that will occur at a later date. This way you extend the marketing window and work on minimizing price risk with a marketing tool that is relatively easy to enter and exit. Keep in mind that margin money needs to be accounted for, the quantity (40,000 pounds) that the contract covers, the basis and exchange rate risk. This article provided a basic overview of using a futures contract as a short hedge to manage price risk. A CME resource with more detailed information, "Self-Study Guide to Hedging with Livestock Futures and Options" is available at www.cmegroup.com.
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