Of all the aspects of pork production, using futures prices and options can be among the more confusing.
This can lead to problems and mistrust on both sides of the contract, making it important to clear the air.
Problems or misconceptions with the contracts have been magnified in recent years by the increased use of the lean-hog contracts. Michael Downs, chairman of the Chicago Mercantile Exchange’s lean-hog-pit committee, says there has been an 8 percent increase in packer contracts, which increases the reliance on the futures market.
The lack of current data to study also has led to problems. Producers and analysts have had to use resources that are up to 15 years old (such as historical basis trends). Among the problems, that data was based on live-hog contracts, rather than the current lean-hog contracts.
“Some people take 15 years of data, but 12 years of it was based on live-hog data,” says Downs. “Add to that the recent 50-year-low hog prices and $85 per hundred-weight lean-hog futures three years ago and the data looks a little flaky. If you’re looking at data from 10 years ago you have to realize it’s a different market now.”
The basis fluctuation has been a sizable frustration for producers, because it has not reacted in line with historical patterns. The changeover to lean-hog contracts three years ago is largely to blame for the variation from historical norms.
“If you use only the three years of data collected since the lean-hog contracts have been available, the basis is more predictable,” says Downs.
Scott Shepard, pork investor trading manager for Cargill, says the basis often appears wider than it may actually be, because packers pass on the high end of basis risk to producers in forward pricing contracts.
“Many producers aren’t using futures options because they have a false sense of basis risk, and because of that they would rather forward contract with packers,” says Shepard.
For example, suppose the October lean-hog futures contract was selling for $55 per carcass hundredweight. With a forward contract the packer would take off basis risk immediately and you would receive $50. Whereas, if you hedged the contract you would get $55, plus or minus the basis, notes Shepard.
Also, a hedge can be bought or sold at any time, but you can’t terminate the packer’s forward contract, he adds.
There are other issues besides basis fears that have discouraged or frightened some producers away from CME forward pricing options.
“Some producers don’t have the extra time or money to feel comfortable with the futures market and those are two huge barriers to entry,” says Shepard.
So, if you are interested in taking advantage of CME forward pricing opportunities what’s the best approach?
“I’m a big advocate of trial by fire,” says Downs. “People can look at historical infor-mation from our marketing department or our webpage, but the best way to learn it is to get in there and hedge.”
Not everyone endorses that strategy. Shepard takes a bit more conservative approach. “I believe you should get your toes wet before you jump in,” he says.
For example, Downs and Shepard both advise starting with one hedge, putting it on and off to get the feel for trading, rather than starting with multiple hedges. This helps reduce risk as you learn the market’s tendencies. One common mistake many hedgers make is holding on to the hedge too long.
“If the contract makes you $2 in two days, take it, don’t wait until the contract expir-ation date,” says Downs.
On the other hand, be wary of crossing the line and becoming a speculator. There are differences in the tax laws between hedgers and speculators.
Another tip is not to expect too much, or react too harshly to price or basis fluctuations.
“I see some of our customers doing a kind of ‘panic hedging’,” says Downs. “I always tell them to be more proactive and less reactive, and don’t try to shoot the moon.” In other words, the surest way to get burned is to try to pick the top or the bottom of the market.
Like the rest of the industry, CME contracts are not standing still. Mandatory price reporting adds yet another angle. If under the new law, sufficient carcass information is provided to CME, price reporting may make for more realistic futures contracts.
Another new wrinkle involves the options on the CMELean-Hog Index with expirations in January, March, May, September and November. This helps fill in the blanks during the months that don’t offer regular futures contracts. The put and call options are settled directly to the lean-hog index, and are listed 120 days before they expire. CME began trading these contracts on June 25.
Also new from CMEis the introduction of quarter-sized, electronically traded “E-mini”futures and options contractson July 25.
Yet another change will be the demutualization of CME. Bottom line, this will mean the exchange will be run more like a business, with a closer eye on profits.
Downs contends that it will be a positive change for the livestock contracts, “because it shows a continued commitment on behalf of the members who will become stockholders.”
So, like everything else, CME forward pricing options will continue to evolve. You can add these options to your risk-management toolbox, provided you work to understand them – and if you understand your risk comfort level.