Trading Challenges

 

The large price swings of the past two months have added to the difficulty of managing risk. Limit moves in futures prices have meant that out-of-the-money options with little or no open interest one week are suddenly actively trading. Desired floor prices could have easily been missed. Options with extremely high or low strike prices tend to be more-thinly traded during quiet times, and seem to have taken on extremely wide bid and ask spreads in recent weeks. This has made entering and exiting futures and options positions more difficult. In addition, it now takes extra effort to discern what the bid and ask prices may be saying about a given futures price or option premium.

 

There are some ways to discern what buyers are saying in their bids and what the sellers are saying in their asks when looking at option premiums. If they are saying the same thing, then there is usually some trading volume, and some insights for the overall market. For options, the insight is measured using the implied volatility, or how much futures are expected to fluctuate moving forward. Various brokerage platforms will provide such information. Volatility is also available on the CME Group’s website using their “Volatility Term Structure Tool”, which provides recent implied volatility levels for various contracts, including live cattle and feeder cattle. When the volatility is too high, it may price a hedger out of the market. Knowing the current volatility level helps explain why premiums may be different than expected and gives a basis for coming up with a bid or ask of one’s own. If bids and asks are widely different, or if the market has just experienced a large change, then plugging a reasonable volatility level into an option calculator can be helpful. Various platforms have these also, but the CME Group’s “Options Calculator” is preloaded with recent price content by contract and expiration month. Thus, one can pull up the details for August feeder cattle and then change the volatility to see other premium levels. This can be done with a bid and ask combination or with a volatility level from a different time period.

 

Given the large moves, the recent futures prices are likely to look unattractive for a producer trying to hedge cattle in the short run. Waiting for the markets to rebound has not proven to be effective. This suggests options may be a prudent path to manage risk. In some cases, it may be feasible to find a contract with low, or relatively low, volatility and offset some risk there by buying put option coverage. There may still be some room to utilize very out-of-the-money put options. In higher volatility level situations, it may be feasible to explore fence strategies, buying a put option at a low strike price and selling a call option at a high strike price to make the strategy more cost-effective. When the volatility is really high, then nothing much is going to look too favorable. If something has to be done, perhaps a synthetic put (combining selling a futures contract and buying an out-of-the-money call option) would be preferred to other strategies. The futures position stops further downside risk. Coupling it with a call option restores some upside price potential. Other combination strategies may also be worth considering. Futures hedges will require some capital for the margin account. Options, especially when the volatility is high, require a substantial upfront outlay to establish.