Buying Feeder Cattle Put Options to Profit from a Fall in Feeder Cattle Prices

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Contents

Buying Feeder Cattle Put Options to Profit from a Fall in Feeder Cattle Prices

If you are bearish on feeder cattle, you can profit from a fall in feeder cattle price by buying (going long) feeder cattle put options.

Example: Long Feeder Cattle Put Option

You observed that the near-month CME Feeder Cattle futures contract is trading at the price of USD 0.9520 per pound. A CME Feeder Cattle put option with the same expiration month and a nearby strike price of USD 0.9500 is being priced at USD 0.0600/lb. Since each underlying CME Feeder Cattle futures contract represents 50,000 pounds of feeder cattle, the premium you need to pay to own the put option is USD 3,000.

Assuming that by option expiration day, the price of the underlying feeder cattle futures has fallen by 15% and is now trading at USD 0.8092 per pound. At this price, your put option is now in the money.

Gain from Put Option Exercise

By exercising your put option now, you get to assume a short position in the underlying feeder cattle futures at the strike price of USD 0.9500. In other words, it also means that you get to sell 50,000 pounds of feeder cattle at USD 0.9500/lb on delivery day.

To take profit, you enter an offsetting long futures position in one contract of the underlying feeder cattle futures at the market price of USD 0.8092 per pound, resulting in a gain of USD 0.1408/lb. Since each CME Feeder Cattle put option covers 50,000 pounds of feeder cattle, gain from the long put position is USD 7,040. Deducting the initial premium of USD 3,000 you paid to purchase the put option, your net profit from the long put strategy will come to USD 4,040.

Long Feeder Cattle Put Option Strategy
Gain from Option Exercise = (Option Strike Price – Market Price of Underlying Futures) x Contract Size
= (USD 0.9500/lb – USD 0.8092/lb) x 50000 lb
= USD 7,040
Investment = Initial Premium Paid
= USD 3,000
Net Profit = Gain from Option Exercise – Investment
= USD 7,040 – USD 3,000
= USD 4,040
Return on Investment = 135%

Sell-to-Close Put Option

In practice, there is often no need to exercise the put option to realise the profit. You can close out the position by selling the put option in the options market via a sell-to-close transaction. Proceeds from the option sale will also include any remaining time value if there is still some time left before the option expires.

In the example above, since the sale is performed on option expiration day, there is virtually no time value left. The amount you will receive from the feeder cattle option sale will be equal to it’s intrinsic value.

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If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

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Dividend Capture using Covered Calls

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Leverage using Calls, Not Margin Calls

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What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

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Buying Live Cattle Put Options to Profit from a Fall in Live Cattle Prices

If you are bearish on live cattle, you can profit from a fall in live cattle price by buying (going long) live cattle put options.

Example: Long Live Cattle Put Option

You observed that the near-month CME Live Cattle futures contract is trading at the price of USD 0.8445 per pound. A CME Live Cattle put option with the same expiration month and a nearby strike price of USD 0.8400 is being priced at USD 0.0600/lb. Since each underlying CME Live Cattle futures contract represents 40,000 pounds of live cattle, the premium you need to pay to own the put option is USD 2,400.

Assuming that by option expiration day, the price of the underlying live cattle futures has fallen by 15% and is now trading at USD 0.7178 per pound. At this price, your put option is now in the money.

Gain from Put Option Exercise

By exercising your put option now, you get to assume a short position in the underlying live cattle futures at the strike price of USD 0.8400. In other words, it also means that you get to sell 40,000 pounds of live cattle at USD 0.8400/lb on delivery day.

To take profit, you enter an offsetting long futures position in one contract of the underlying live cattle futures at the market price of USD 0.7178 per pound, resulting in a gain of USD 0.1222/lb. Since each CME Live Cattle put option covers 40,000 pounds of live cattle, gain from the long put position is USD 4,888. Deducting the initial premium of USD 2,400 you paid to purchase the put option, your net profit from the long put strategy will come to USD 2,488.

Long Live Cattle Put Option Strategy
Gain from Option Exercise = (Option Strike Price – Market Price of Underlying Futures) x Contract Size
= (USD 0.8400/lb – USD 0.7178/lb) x 40000 lb
= USD 4,888
Investment = Initial Premium Paid
= USD 2,400
Net Profit = Gain from Option Exercise – Investment
= USD 4,888 – USD 2,400
= USD 2,488
Return on Investment = 104%

Sell-to-Close Put Option

In practice, there is often no need to exercise the put option to realise the profit. You can close out the position by selling the put option in the options market via a sell-to-close transaction. Proceeds from the option sale will also include any remaining time value if there is still some time left before the option expires.

In the example above, since the sale is performed on option expiration day, there is virtually no time value left. The amount you will receive from the live cattle option sale will be equal to it’s intrinsic value.

Learn More About Live Cattle Futures & Options Trading

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Continue Reading.

Buying Straddles into Earnings

Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

What are Binary Options and How to Trade Them?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]

Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

Buying Feeder Cattle Put Options to Profit from a Fall in Feeder Cattle Prices

Posted January 1999

Purchasing calves (stockers) in spring and selling them in the fall as feeder cattle may be a way to convert pasture to profit for those with a surplus of grass but not a lot of facilities. But managing pasture, animals, costs, and markets plays a key role in determining the level of profit producers can expect. “Producers who have a solid understanding of their costs and rates of gain can use a simple management tool to determine what spring calf prices will make money for them in the fall,” says Don Schuster, economist with the Center for Integrated Agricultural Systems (CIAS).

Schuster worked with a UW-Madison team including Rick Klemme, CIAS director, Dan Schaefer and Mike Siemens of Animal Sciences, Dan Undersander of Agronomy, and stocker operator and veterinarian Larry Smith to develop a stocker budget. They modeled financial returns to farmers using beef stockers (those from beef cattle breeds) and Holstein stockers over a six-month grazing season, and used the model to calculate costs and returns on a per head and per acre basis for the stocker and pasture enterprises. They also developed a set of tables that show break-even points for both beef and Holstein stockers.

Scenario assumptions

The enterprise budgets require several assumptions. Both stocker types graze 200 days on a total of 100 acres. They use management intensive rotational grazing (MIRG), which results in higher grass production, higher stocking rates, and increased profits per acre compared to continuous grazing.

The enterprise budget takes into consideration costs of labor, pasture, minerals, implants, marketing, veterinary, pumping water, interest, and miscellaneous needs. It assumes that the producer already has basic equipment for fence construction and maintenance and cutting and raking hay. Equipment costs include depreciation, fuel, and maintenance.

Costs associated with seeding the pasture are included, but fertilizer costs are not, since existing soil test levels and stocker manure are assumed to provide adequate nutrients for pasture growth. Pasture yields are 4 tons (3.4 tons dry matter, dm) per acre, which exceeds the stockers’ needs. The surplus forage is custom round baled, with the beef stocker providing less hay than the Holstein operation. The 100 acres used in the operation has an exterior fence with six interior paddocks. Water, piping, and tank costs are included, as are the cost of a loading chute and gates for handling the cattle.

The land rent is assumed to be $60 per acre. Schuster says, “This cost is almost 10 percent below the 1992 state average, but most likely poorer quality land would be used for grazing. Significantly higher rent will have a negative impact on profit potential, unless yields and stocking rates can be increased.”

The team’s assumptions resulted in a per head net return (profit) of $85.17 for the beef stockers and $71.08 for the Holstein stockers.

Assumptions used for stocker scenarios
Scenario variable Beef stockers Holstein stockers
Purchase weight 500 lbs. 300 lbs.
Purchase price $0.80/lb. $0.90/lb.
Stocking rate 1.4 head/acre 1.5 head/acre
Death loss 1 percent 2 percent
Daily dry matter intake 2.8 % of body weight 3.2 % of body weight
Daily rate of gain 2.2 lbs. 2 lbs.
Selling weight 940 lbs. 700 lbs.
Selling price $0.68/lb. $0.68/lb.

Break-even purchase prices

Farmers who wish to wish to evaluate a stocker enterprise’s profitability need to know how much they can pay for calves in the spring and still make a profit in the fall. The team developed a table to help farmers calculate this figure, based on the scenario. They calculated the point where returns equal costs (break-even points) by varying daily rate of gain and price spread. “Reading down and across the tables, producers will find a predicted break-even purchase price for stockers using our budget. Profit is zero at the break-even price, so farmers need to calculate and add a targeted profit,” Schuster says.

For example, a producer who is buying beef stockers with expectations of selling them in the fall for $0.65 per pound with a daily rate of gain of 2.2 pounds per day can pay up to $0.93 per pound for calves and break even. A producer who is buying Holstein stockers that will gain 2 pounds per day and sell for $0.65 per pound in fall can pay up to $1.09 per pound in spring and break even.

Daily rate of gain has an important impact on the profitability of the operation. Assuming prices and costs described in the budget scenario, the break-even rate of gain for beef and Holstein stockers was just under 1.5 pounds per day.

The break-even purchase price tables show the importance of the daily rate of gain in another way. For a producer who receives a fall price of $0.60 per pound on beef stockers, increasing the daily rate of gain from 1.4 to 2.0 pounds per day means that he or she can spend $0.15 more per pound on calves in the spring and still break even.

The team found that each additional 0.1 pound of gain per day for both beef and Holstein stockers is worth about $13 (net) per head when they are sold, using the numbers in this example, and keeping in mind that prices per pound may decrease as weights increase. In addition, extra costs incurred in increasing the rate of gain would have to be deducted.

The difference between the price paid for the calves in spring and received for them in fall, called the “price spread,” is also a key variable. In this example, beef stockers are purchased for $0.80 per pound and sold for $0.68 per pound, a price spread of $0.12. The break-even selling price for beef stockers was $0.59 per pound, which is a $0.21 price spread. Every $0.01 change in price spread for beef stockers is worth about $10 per head on this operation.

The budget assumed a $0.22 price spread for the Holstein stockers. The break-even selling price for Holstein stockers is just under $0.58 per pound, which is a $0.32 price spread. For the Holstein stockers, every $0.01 per pound change in price spread resulted in a difference of $7 per head.

The break-even purchase price tables highlight how price spread affects financial performance. When a producer of Holstein stockers receives a fall price of $0.70 per pound, and pays only $0.93 per pound in the spring (a price spread of $0.23), the cattle only need to gain 1.4 pounds per day for the producer to break even. But when the producer pays $1.39 per pound in the spring (a price spread of $0.69), the cattle need to gain 2.4 pounds per head per day for the operation to reach the break-even point.

Stockers can be a good fit

This budget shows profits ranging from $80 to $100 per head with a management charge of $18 per acre included. Klemme warns, “If any of the costs turn out to be higher than in this scenario, rate of gain lower, or the sell-purchase price spread more than expected, these profits can rapidly disappear.” For example, a 10 percent decrease in the rate of daily gain from the budget example reduces profit by $29.85 per beef stocker and $27.14 per Holstein stocker. A 10 percent drop in the selling price compared to the budget price results in a decrease in profit of $63.91 per beef stocker and $47.60 per Holstein stocker.

The financial success of a stocker operation will depend on some factors which are largely outside of the producer’s control, like weather and price spread. Some producers use hedging instruments in the form of forward, futures, or options contracts to protect their prices. Others follow market reports closely or rely on many years of marketing knowledge to decide how and when to sell their cattle to receive the best prices. But by having some control over costs, rates of gain, and type of stockers, producers can estimate their profits based on spring calf prices and fall feeder prices.

Beef stocker break-even purchase prices ($/lb.)
Gain Selling prices ($/lb.)
(lbs./day) $0.45 $0.50 $0.55 $0.60 $0.65 $0.70
1.4 $0.42 $0.49 $0.57 $0.64 $0.72 $0.80
1.6 0.45 0.53 0.60 0.69 0.77 0.85
1.8 0.48 0.57 0.65 0.74 0.82 0.91
2.0 0.52 0.61 0.70 0.79 0.88 0.96
2.2 0.55 0.65 0.74 0.83 0.93 1.02
2.4 0.59 0.69 0.78 0.88 0.98 1.08
2.6 0.63 0.73 0.83 0.93 1.03 1.13
2.8 0.66 0.77 0.87 0.98 1.08 1.19
Holstein stocker break-even purchase prices ($/lb.)
Gain Selling prices ($/lb.)
(lbs./day) $0.45 $0.50 $0.55 $0.60 $0.65 $0.70
1.4 $0.45 $0.54 $0.64 $0.74 $0.83 $0.93
1.6 0.51 0.61 0.71 0.81 0.92 1.02
1.8 0.57 0.68 0.78 0.89 1.00 1.11
2.0 0.63 0.74 0.86 0.97 1.09 1.20
2.2 0.69 0.81 0.93 1.05 1.17 1.30
2.4 0.75 0.87 1.00 1.13 1.26 1.39
2.6 0.79 0.93 1.06 1.20 1.33 1.47

Published as Research Brief #36
January, 1999

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