AGRICULTURAL PRODUCTS

Self-Study Guide to Hedging
with Livestock Futures and Options

In a world of increasing volatility, CME Group is where the world comes to manage risk across all
major asset classes – agricultural commodities, interest rates, equity indexes, foreign exchange,energy and metals, as well as alternative investments such as weather and real estate. Built on
the heritage of CME, CBOT, KCBT and NYMEX, CME Group is the world’s largest and most diverse
derivatives exchange encompassing the widest range of benchmark products available, providing
the tools customers need to meet business objectives and achieve financial goals. CME Group brings
buyers and sellers together on the CME Globex electronic trading platform. CME Group also operates
CME Clearing, one of the world’s leading central counterparty clearing providers, which offers
clearing and settlement services across asset classes for exchange-traded contracts and over-thecounter derivatives transactions. These products and services ensure that businesses everywhere cansubstantially mitigate counterparty credit risk.

AGRICULTURAL PRODUCTS
MORE AGRICULTURAL FUTURES AND OPTIONS. GREATER OPPORTUNITY.
CME Group offers the widest range of agricultural derivatives of any exchange, with trading available
on a variety of grains, oilseeds, livestock, dairy, lumber and other products. Representing the staplesof everyday life, these products offer liquidity, transparent pricing and extraordinary opportunities in a
regulated centralized marketplace with equal access for all participants.

Livestock Self Study Guide

IN THIS GUIDEINTRODUCTION TO THE GUIDE

3

CHAPTER 1: Overview of the Livestock Futures Market

5

CHAPTER 2: Financial Integrity of the Livestock Futures Market

12

CHAPTER 3: Livestock Cash Market Basis and General Hedge Theory

14

CHAPTER 4: Short Futures Hedge

20

CHAPTER 5: Long Futures Hedge

25

CHAPTER 6: Overview of the Livestock Options Market

30

CHAPTER 7: Option Strategies for Livestock Buyers

38

CHAPTER 8: Option Strategies for Livestock Sellers

44

CHAPTER 9: Keys to Successful Livestock Risk Management

50

CHAPTER 10: Additional Risks of the Livestock Hedger

53

SUMMARY
APPENDIX:
Getting Started, Additional Resources and Quiz Answer Keycmegroup.com/agriculture

INTRODUCTION TO THE GUIDEThe agricultural commodity markets have experienced
increased volatility in recent years. As part of thismarket trend, livestock buyers and sellers are facing
an ever-increasing level of price risk. Doing nothing
to manage price risk is tantamount to speculating in
the physical (or “cash”) markets, which can prove
unhealthy to the bottom line of a livestock producer
or commercial firm.
CME Group livestock futures and options provide
livestock buyers and sellers with valuable tools tomanage price risk and have more control over theirbottom line. This guide is designed to provide a
detailed overview of using futures and options for risk
management in the livestock markets.

The early chapters will establish a foundation thatthe latter chapters will build on. For someone new
to livestock price risk management, it may help tomove sequentially through the chapters to get a basic
understanding of the core concepts and fundamentals.
Those with some experience may wish to proceed tothe chapters with topics on which they may need arefresher, or perhaps would like a different perspective.
Each chapter ends with a brief quiz which allows
readers to test their grasp of the material.
Regardless of how the guide is used, the objective isto enhance the hedger’s knowledge of using livestock
futures and options to manage market risk.

Monthly
Historical
Volatility– LivestockAug
2012
Monthly
Historical
Volatility– LivestockAug
2012totoAug
Aug2017
2017

5

ec
-1
3
Ap
r-1
4
Au
g14
D
ec
-1
4
Ap
r-1
5
Au
g15
D
ec
-1
5
Ap
r-1
6
Au
g16
D
ec
-1
6
Ap
r-1
7
Au
g17

-1
3

D

-1
3

Au
g

12

Ap
r

ec
-

D

Au

g1

2

0

Live Cattle

Lean Hogs

Feeder Cattle

Source: CME Group4

Oct-09

10

Jul-0915

Apr-0920

Jan-0925

Jul-0830

Oct-08Percent Volatility

35

Apr-08

90%
80%
70%
60%
50%
40%
30%
20%
10%
0%

40

Jan-0845

Lean Hogs

Livestock Self Study Guide

CHAPTER 1 OVERVIEW OF THE LIVESTOCK
FUTURES MARKET
What is a Livestock Futures Contract?
A Livestock futures contract is a legally binding
agreement for a buyer to accept delivery and a seller
to make delivery of:• a standardized quantity and quality of a specified
livestock product (live cattle, feeder cattle or lean hogs),• during a standardized time period,• to a standardized delivery point,• for a price negotiated at the CME Group (CME),
on the CME Globex electronic trading platform.

Important Concepts of Livestock Futures
A futures contract is not a written document. Hedgers
will get regular statements regarding their futures
position from their brokers, but they will never receive
a written contract. However, a futures contract is still alegally binding agreement that is just as enforceable asa written contract, to the full extent of the law.
Price is the only negotiable element of a futurescontract. Futures contract prices are determinedthrough the interaction between the buyer and theseller, representing demand and supply, respectively.
The prices are not set by the CME. The CME simply
provides the marketplace, futures products, technology,
rules and regulations for the buyers and sellers tocome together.
Although every futures contract involves a buyer(making bids) and a seller (making offers), neither
party knows who is on the other side of the transaction.
The buy or sell obligation is with the marketplaceand not with an individual participant. A common
misconception is that a speculator is always on theother side of a hedger’s position, which is not accurate.
A transaction could involve two hedgers, two
speculators, or a hedger and a speculator.

Futures Terminology

The futures industry uses some terms that are very
unique to this market, and some that are common toother markets. A few of the more important terms aredescribed below; related terms are listed together forcomparison and better understanding.
The cash market is also known as the physical orunderlying market. These are specific market locations
where the exchange of a physical product for payment
takes place. As such, there are many cash markets
located throughout the world. Hedgers may even haveseveral cash markets near their location. Cash market
prices may be different based on where they are located.
A futures market is a centralized market place that isoften described as a “benchmark” market. Note that a
futures market price is the same for buyers and sellers,
regardless of the type of trader they are or where
they are located. A futures market price is determinedthrough the interaction of the buyers (demand) and thesellers (supply).
A bid is an expression to buy and represents thedemand for a product. Although a buying hedger
would like to buy at the bid, in reality, they will usually
buy at the offer, i.e., where someone is willing to sell.
An offer is an expression to sell and represents the
supply of a product. Although a selling hedger would
like to sell at the offer, in reality, they will usually sell atthe bid, i.e., where someone is willing to buy.
A tight bid/offer spread occurs when the bids andoffers are close together, and is a reflection of themarket’s efficiency and liquidity. Market efficiency
and liquidity are important to a hedger when they are
initiating and closing out their futures market positions.

A long futures position is an initial buy position that5

cmegroup.com/agriculture

represents an obligation to accept delivery of thestandardized commodity.
A short futures position is an initial sell position that
represents an obligation to make delivery of thestandardized commodity.
To offset or close-out an existing futures position is tosimply take the opposite position in the same futurescontract and delivery month.
• If initially long, offset by selling back theidentical contract• If initially short, offset by buying back theidentical contract
Bear or bearish reflects lower or declining market prices
and are directional terms often used to describe a trader,market movement, trend, strategy or opinion. A bearish
strategy provides opportunity if the market moves lower.
Bull or bullish reflects higher or increasing prices
and are also directional terms often used to describe
a trader, market movement, trend, strategy or opinion.
A bullish strategy provides opportunity if the market
moves higher.
Volume is the number of futures contracts that aretraded in a given time period. Although volume isquoted for different time periods, the most common
is daily volume.
Open Interest is the number of contracts that have
traded, but have not been closed out either throughoffset or delivery. Many market participants view
open interest as a measure of the contract’s liquidity
or pricing efficiency.
A Futures Commission Merchant (FCM) is anotherterm for a commodity broker. The only way to trade
futures or options is through a broker or FCM.

Livestock Contract Specifications
6

A futures contract is designed with specifications
to match cash market commodities and industry
standards. The CME constantly monitors industry
standards and cash market practices. If there are
significant changes, the Exchange will consult withmarket participants to determine if modifications to
the futures contract specifications are necessary.
The specifications help to ensure that there is a twoway relationship between the benchmark livestock
futures market and the numerous livestock cash
markets. The price that is discovered in a futures
market comes from the interaction between the
supply (sellers’ offers) and demand (buyers’ bids).
Many of these bids and offers come from cash market
participants. In turn, the futures contract price isthen used by cash market participants to transact
in the spot (current) market or for cash forward typecontracts. Note that many cash market contracts are“based on” or “referenced to” the futures market price.

Physical Delivery versus Cash Settlement
Although many futures contracts are traded, very
few will ever result in actual delivery of the physicalcommodity. The great majority of futures contracts
are closed out, or “offset” prior to delivery by taking an
opposite position in the same contract and delivery
month. In other words, if someone initially buys afutures contract for a specific product and delivery
month, and later sells a futures contract for the same
product and delivery month, their position and market
obligation is closed out. Conversely, if someone initiallysells a futures contract and later buys back the same
contract, the market obligation is closed out.

Livestock Self Study Guide

There are two types of settlement for futures contracts:
physical delivery and cash-settlement.
• The Live Cattle futures contract requires physicaldelivery settlement in which live cattle are delivered. The
CME Rulebook dictates the specific standards in termsof the quantity and quality (USDA Grades) of cattle thatcan be delivered. The seller of the Live Cattle futurescontract makes the final decision regarding the actual
quality and quantity that will ultimately be delivered,but it must be within the standards authorized by the
Exchange. Any variations to the standardized quantity
or quality may be subject to premiums or discounts
to the futures price. The specific details of the physicaldelivery requirements specified in the CME Rulebook
can be found at cmegroup.com/rulebook.
• The Feeder Cattle and Lean Hog futures contracts
are cash (or “financially”) settled contracts. All
outstanding contracts that remain open after thelast trading day will be automatically closed out ata price set equal to the CME Feeder Cattle Index or
the CME Lean Hog Index on the last trading day. This
final cash settlement cancels the obligation of thebuyer and the seller. The specific details of the cashsettlement process are also specified in the CME
Rulebook at cmegroup.com/rulebook.
The CME’s Live Cattle futures contract requires deliveryof live cattle during the contract month for all market
participants who still have an open long position(obligations to accept physical delivery) or shortposition (obligation to make physical delivery) basedon the latest Exchange rules and regulations.
The primary purpose of a futures contract is price risk
management and not delivery of the actual or physicalcommodity on the futures contract. As such, it is usuallymore feasible in economic terms to deliver or accept
delivery in a local cash market. Physical delivery on a
Live Cattle futures contract is normally less than 1% of
the total futures volume.

Then, why is there a physical delivery requirement
on a futures contract? It is the possibility of physicaldelivery that causes the cash and the futures markets
to converge at contract expiration. It also contributes
to the necessary and vital market economic function
known as price correlation, which keeps the cash andfutures markets’ prices moving in the same direction
throughout the life of the futures contract.
As previously mentioned, the CME’s Feeder Cattle andLean Hog futures contracts have a cash settlement
requirement. Although it is a different type of delivery
system than Live Cattle, the objectives are the same:
cash/futures convergence and correlation.
In the cash-settlement procedures, all long contracts still
open after the last trading day are automatically offset
against all remaining open short contracts. They aresettled to a price equal to the CME Feeder Cattle Index
or to the CME Lean Hog Index on that day (see insert).

Feeder cattle and lean hog indexes
The CME Feeder Cattle Index and the CME Lean Hog
Index are calculated by CME Group staff using UnitedStates Department of Agriculture (USDA) data. The
data and the formula used to calculate the final cash
settlement price are made available to the public andcan be found at cmegroup.com/feedercattle andcmegroup.com/leanhogs, respectively. Additional details
on the cash-settlement process for Lean Hogs and Feeder
Cattle futures can be found in the CME Rulebook locatedat cmegroup.com/rulebook.

7cmegroup.com/agriculture

The following table indicates the key features of the CME Livestock futures contracts. This will facilitate
understanding of the basics of each contract, allowing readers to follow the examples used in this Hedging Guide.
Highlights of CME Livestock Futures Contracts
CME Live Cattle

CME Feeder Cattle

CME Lean Hogs

Contract Size

40,000 Pounds (lb.) = 400
hundredweight (cwt)

50,000 Pounds (lb.) = 500 cwt

40,000 Pounds (lb.) = 400 cwt

Price Unit

Cents per pound or
Dollars and Cents per cwt

Cents per pound or
Dollars and Cents per cwt

Cents per pound or
Dollars and Cents per cwt

Tick (minimum
price change)$0.00025 per pound =$0.025 per cwt = $10/contract$0.045 per pound above or below
the previous day’s settlement price,
expandable to $0.0675$0.03 per pound above or below
the previous day’s settlement
price, expandable to $0.045

Daily Price Limits$0.03 per pound above or below
the previous day’s settlement price,
expandable to $0.045$0.03 above or below the previous
day’s settlement price$0.03 above or below the previous
day’s settlement price

Delivery Type

Physical Delivery

Cash (financial)

Cash (financial)

Contract Months

Feb(G), Apr (J), Jun(M), Aug(Q), Oct(V),Dec (Z)

Jan (F), Mar(H), Apr(J), May(K),
Aug(Q), Sep(U), Oct(V), Nov(X)

Feb(G), Apr(J), May(K), Jun(M),
Jul(N), Aug(Q), Oct(V), Dec(Z)Ticker Symbol
CME Globex

LE

GF

HE

Trading Hours
CME Globex

Monday - Friday: 8:30 a.m. to 1:05 p.m. CT

For additional livestock futures contract specifications visit cmegroup.com/agriculture.

8Livestock Self Study Guide

Participants
All futures markets participants can be classified in oneof two ways, depending on their objectives of either
managing price risk, or assuming price risk.
A hedger is an individual or firm that uses the futures
market to manage or reduce the price risk associatedwith their cash market position. A livestock hedger
eventually buys or sells the physical livestock productor by-product in the cash market. Hedgers will choose
the futures contract that matches their underlying
physical market commodity.

Speculators provide a major benefit to hedgers andthe marketplace alike – market liquidity. Market liquidity
is a measure of the market’s efficiency, and it is thisefficiency that results in better bids and offers for all
market participants, including the hedger. Liquidity isalso key
to the ability to initiate and offset futures positions.

Platforms
CME Globex is the premier global electronic platform
for trading livestock futures and options as well asother products at CME Group exchanges.

Sometimes there are physical livestock products that
do not have a corresponding futures contract that
directly matches the underlying market. As such, across-hedge strategy can be employed, using a CME
Livestock futures contract to manage the price risk ofa different, but related, livestock/meat product which
is not traded in the futures market. To ensure theefficiency of a cross-hedge, there must be a strong
correlation between the futures price and the cash
price of the different livestock/meat product.
The other type of futures industry participant is the
speculator, an individual or firm that assumes pricerisk by buying or selling livestock futures in an attempt
to profit from a potential change in price or pricerelationship. The futures market speculator usually does
not hold or plan to acquire the cash product.

9cmegroup.com/agriculture

QUIZ 1
1.	In which market does a livestock hedger usually
deliver or accept delivery of the physical livestock?

5.

a. The contract buyer sets the pricea. Futures market

b. The Exchange sets the priceb. Option market
c. Swap marketc. P rices are discovered through bids and offers
between buyers and sellers

d. Local cash market

d. T he contract seller dictates the price2.	What happens to the obligations of most futurescontracts used in a hedge?
a. They expire worthlessb. They are physically deliveredc. They are closed-out by an offsetting transactiond. They are converted into a swap contract
3.	Which of the following is the only variable elementof a standardized livestock futures contracts?
a. Quantity
b. Quality
c. Time of deliveryd. Place of delivery
e. Price
4.	If you are long a CME livestock futures contract:6.

Who is on the other side of a hedger’s position?
a. Speculator
b. Another hedgerc. Could be either a hedger or a speculator
d. The Exchange

7.	Who provides the greatest amount of market
liquidity?
a. Hedgers
b. Speculatorsc. The Exchange
d. The Clearing House
8.	Who has the right to choose the trading platform
when initiating or closing out a position?
a. CME Groupa. You have an obligation to accept deliveryb. Broker

b. You have an obligation to make deliveryc. You, the customerc. You have the right but not an obligation toaccept delivery

d. Clearing firmd. You have the right but not an obligation to
make delivery

10

Where does a livestock futures price come from?

Answers are located in the Appendix.

Livestock Self Study Guide

11cmegroup.com/agriculture

CHAPTER 2 FINANCIAL INTEGRITY OF
THE LIVESTOCK FUTURES MARKETOne of the key benefits of the futures market is thefinancial integrity of every contract that is tradedand cleared at the exchange, a role fulfilled by CME
Clearing. The obligation of a futures contract is ensured
through the concept of margin or performance bond.
Every buyer and every seller of a futures contract must
post and maintain a margin account to ensure theiradherence to the terms of the futures contract. The
Exchange establishes a minimum margin requirement
per contract, called the “initial” margin, which usually
ranges from 5–15% of the contract value. However,brokers may require their customers to post a margin
that may be higher than the Exchange minimum.
Margin is deposited into a “segregated” trading
account with the customer’s FCM. In segregatedaccounts customers’ deposits are not commingled with
their FCM’s proprietary funds.
Although the absolute amount of margin is not a
cost of trading futures, there is a cost associatedwith margin: interest. This can be the interest paidon the amount borrowed to fund the margin, or theopportunity cost of not having the earning poweron the funds used as margin. It is not necessary todeposit cash as initial margin; there are different typesof financial instruments that are acceptable to post
as the initial margin requirement. As some forms ofacceptable initial margin are interest bearing, thedeposit of these forms of capital allow the customer toretain the earning power.

12

Once a position is initiated in a futures contract, themargin account will be adjusted twice daily, based on
movements in the futures market. The margin accountwill receive a credit if the futures market moves infavor of the customer’s position, or will be debited if
the futures market moves against the position. This
daily adjustment process, called marked to market,
is based on the futures contract’s settlement price forthat day. Every open position for a particular futurescontract will be marked to market at the end of the
trading day against the same daily settlement pricefor that contract.
A margin call is a request from the commodity broker
for the customer to deposit additional funds into their
margin account. This occurs when the balance in themargin account falls below a specified maintenancemargin level. The amount of the additional margin to
be deposited must be enough to return the marginaccount balance back to the initial margin level.
Market participants receive margin calls when the
futures market moves against their position.
• With a long (buy) futures position, a margin call isreceived if the market moves low enough to cause
the margin account balance to fall below themaintenance level.
• With a short (sell) futures position, a margin call isreceived if the futures market moves high enough tocause the margin account balance to fall below themaintenance level.

Livestock Self Study Guide

Note for hedgers
A hedger’s cash market position is always opposite totheir futures market position. So if the futures market
moves against a hedger’s futures position, possibly
resulting in a margin call, their cash market position
should simultaneously be improving. This will be clarified
in the later chapters highlighting hedge examples.
The margin system is a key concept which ensures thefinancial integrity of each and every futures and option
contract cleared by CME Clearing.

3.	What happens to a customer’s margin funds thatare posted?
a. Investedb. Used to pay the commissionsc. P ut in a segregated margin account to ensure
contract performanced. Deposited in any bank
4.	Generally speaking, what percentage of a contract
value is initial margin?
a. 50%
b. 100%To access additional information on margins,
including current requirements, acceptable types,
and an example of how they work, visit
cmegroup.com/clearing.

c. 5-15%
d. 200%5.	Which futures market participants are required tohave a margin account?
a. Hedgers
b. Speculatorsc. All traders

QUIZ 2
1.	What guarantees the financial integrity of a futurescontract?

Answers are located in the Appendix.

a. Premiumb. Individual trader’s wordc. Margin
d. Commission
2.	When will a trader get a margin call on a shortfutures position?
a. When a futures market increase causes themargin account balance to fall below thespecified maintenance levelb. Whenever the broker wantsc. When the market settlement price remains
steadyd. Every day regardless of what happens to themarket settlement price13

cmegroup.com/agriculture

CHAPTER 3 LIVESTOCK CASH MARKET, BASISAND GENERAL HEDGE THEORY“Basis” is the most important factor impacting theresult of a hedge strategy using either futures or
options. The concept of basis is vital because it helps a
livestock or meat buyer and seller determine:
1. If they should use futures (or options) to manage
the price risk of their eventual cash market
purchase or sale, and if so,

Cash price

Minus Futures price

Equals Basis$92.00/cwt.

$90.00/cwt.

+ 2.00 or 2.00 over

$85.00/cwt.

$90.00/cwt.

- 5.00 or 5.00 under$90.00/cwt.

$90.00/cwt.

0, even or no basis

2. When to initiate, modify or close out their futures
or options position, and thenBasis equation

3. Who they should eventually buy the actual
livestock from or sell it to in the cash market

Keep in mind that although the basis equation isrelatively simple and the amount of time required forthe calculation is minimal, the importance and value ofmaintaining the local basis information should never be
under-estimated.

What is Basis?
Basis is the relationship between a cash market priceand a futures contract price. As such, basis reflects thecorrelation of the hedger’s local cash market to the futures
market. The better the correlation between the twomarkets, the more effective the hedge strategy will be.

Basis equation:
Cash Market Price – Futures Market Price = Basis

14

Examples of Different Basis Levels:

Livestock Self Study Guide

Which Cash Market Price is Used?
Cash markets are the locations where the hedger
regularly buys or sells the physical livestock product.
There are numerous livestock cash markets in the world,
but a hedger only needs to be concerned with their local
cash market(s). If they have more than one local cash
market that they regularly buy livestock from or sell to,then they will have more than one basis to monitor.
	Note that even if a hedger uses futures contracts to manage pricerisk, the eventual purchase or sale of the physical livestock productwill usually occur at one of their local cash markets. As statedearlier, basis will be one of the deciding factors to determine the
cash market in which they eventually transact.

Which Futures Market Price is Used?
Since there are also many different contract months
for the same livestock futures product, the one thehedgers uses depends on whether they are calculating
a current basis or a deferred basis.
For calculating a current basis, the hedgers should use
today’s cash market price minus the nearby futurescontract price. The nearby futures contract is themonth that is closest to the current time period, but not
before.
	Example 1: If today is March 1, then use the April Live Cattle
futures contract	Example 2: If today is September 5, then use the October Lean
Hog futures contract	Example 3: If today is December 10, then use the January
Feeder Cattle futures contract

The current basis calculation is the more common of
the two and will provide an excellent history of what
the basis is expected to be at any given time of theyear in the local cash market. Although basis history is
not an exact science, it is a valuable tool in helping tomanage cash market risk.

For calculating a deferred basis, the hedger uses a
forward cash market quote minus the price of the
futures contract month which is closest to but not
before the specific time period when he plans tobuy or sell the physical livestock product.
	Example: In January, if a hedger gets a cash forward market quotefor March physical delivery of cattle, they would use the April Live
Cattle futures contract price in calculation of the deferred basis, i.e.,
Cash Forward Price (for March delivery) minus April Futures= Deferred Basis

A deferred basis can be compared to what the hedgers
expects the basis to be at a specific time period in
the future. This comparison will help determine if
one should use a futures contract or a cash market
alternative, such as a cash forward contract, for theirrisk management positions. If the cash contract thatis being offered has a better basis than is expected at
the time of physical delivery, then they may choose to
use the cash contract. However, if the expected basis isbetter than what is being offered via the cash market
contract, then they may decide to use a futures market
contract for their risk management needs.
In other words, the decision to use a futures contract or
cash forward contract for hedging will depend on how
the basis is expected to change from the current time
period, to the time period that the hedger expects tobuy or sell the physical livestock product.

How Can Basis Change?
Cash market prices and a futures market price for thesame livestock product should be correlated, meaningthat the two prices should move up and down together.
Although the two markets should move in tandem,
they don’t necessarily move by the same amount. Any
difference in the change in one market’s price relative
to the other market’s change is a change in basis.

15

cmegroup.com/agriculture

Stronger Basis

Who Benefits From a Stronger Basis?

If the cash market price increases relative to the futures
market price, then the basis is said to have strengthenedor gotten stronger—the key word is “relative.” It highlightsthat a basis can strengthen when prices are moving
higher or when prices are moving lower.

As we have learned so far, the cash market price is alocal factor and the futures market price is a global
benchmark that affects everyone who buys or sells thatlivestock product, regardless of where they are located.

Stronger Basis When Price Levels Increase
Basis can strengthen if the cash market price increases
by an amount greater than the increase in the futures
market price.
	Example: If the cash market price for live cattle increased by $2 perhundred weight (cwt) and the Live Cattle futures price increased by $1
per cwt, then the basis strengthened by $1 from the previous basis level.

Stronger Basis When Price Levels Decrease
Basis can also strengthen when the cash market pricedeclines by an amount less than the decline in the
futures market price.
	Example: If the cash market price for hogs declined by 50 cents per
cwt and the Lean Hog futures price declined by 70 cents per cwt,
the basis strengthened by 20 cents per cwt.

In other words, the futures contract price is identicalfor all market participants at any given time, while thehedger’s cash market price is pertinent only to thosein his local area. Therefore, the hedger’s basis is areflection of his local cash market relative to the global
benchmark futures market. As such, selling hedgers ofphysical livestock products will benefit if and when thebasis strengthens. After all, sellers prefer selling in a“strong” cash market rather than a weak cash market.
Therefore, if the basis strengthens over time, the seller
will receive a relatively higher net selling price.

Weaker BasisIf the cash market price decreases relative to a futures
market price, then the basis has weakened or gotten weaker.
Again, the key word is “relative.” It highlights that a basis
can weaken when prices are moving lower or higher.

Weaker Basis When Price Levels Decrease
Strengthening basis
Note that when a local basis number becomes more positiveor less negative over time, the basis has strengthened.

+1.50

Stronger Basis
Movement
Strengthen
More positive orLess negative Benefits
Short Hedgers

+1.00
+0.50
+0
-0.50
-1.00
-1.50

16

Basis can weaken if the cash market price decreases
by an amount greater than the decrease in the futures
market price.
	Example: If the cash market price for feeder cattle decreased by$1.50 per cwt and the Feeder Cattle futures market price decreased
by $1 per cwt, then the basis weakened by 50 cents from theprevious basis level.

Weaker Basis When Price Levels Increase
Basis can also weaken when the cash market priceincreases by an amount less than the increase in the
futures market price.
	Example: If the cash market price for hogs increased by 50 cents
per cwt and the Lean Hog futures price increased by 60 cents per
cwt, the basis weakened by 10 cents per cwt.

Livestock Self Study Guide

Weakening basis
Note that when a local basis number becomes less positiveor more negative over time, the basis has weakened.

Some people prefer to track the weekly basis. For thistype of information, it is important to be consistent inusing data from the same day every week. Many market
participants who track basis weekly may prefer to use
data from Tuesday, Wednesday or Thursday, rather thanfrom Monday or Friday, which may have greater volatility.

+1.50
+1.00

Weaker Basis
Movement+0.50

WeakenLess positive orMore negative
Benefits Long Hedgers

As such, calculating the daily basis is the mostcommon. The hedger should use the local cash market
price that occurs around the time of the futures market
settlement (currently 1:00 p.m. Chicago time) and thefutures contract’s daily settlement price.

+0
-0.50

Although initiating a historical basis table and/or basis
chart and moving forward may be easy, it may take alittle more work to obtain local basis information fromthe past. However, hedgers may find this additional
research effort very worthwhile when they begin theirprice risk management program.

-1.00
-1.50

Who Benefits From a Weaker Basis?
Think about the market participants who may prefer
to buy in a weak cash market. Following this rationale,buyers of physical livestock products (buying hedgers) will
benefit if and when the basis weakens. That is, if the basis
weakens over time, the buyer will pay a relatively lower
net purchase price.

Getting Started With BasisA hedger may start their research by contacting local
hedge brokers, county extension offices, lenders, ormarket advisors. Also, university livestock marketing
professors may have basis information for their area.

Tracking Basis
Basis can be done with pencil and paper, or on a computer
spreadsheet. The following is a sample cattle basis table:

One of the first things the hedger needs to decide is how
often to calculate his local basis–usually more data is better.

Sample Basis Spreadsheet
Date (MM/DD/YR)

Cash Market

Futures
Contract Month

Basis

Comments

03/15/xxxx

115.00120.00 (April)- 5.00

Heavy local selling

03/16/xxxx

116.50121.00 (April)- 4.50

Selling slows pace

03/17/xxxx

115.00120.50 (April)- 5.50No news

Once the data is collected in tabular form, the hedger may want to create a basis chart, which will provide a
visual effect of the basis changes.
17cmegroup.com/agriculture

Seasonal Live Cattle Basis 2008 – 2016
10.00
8.00
6.00
4.00
2.00
0.00

Jan

Feb

Mar

Apr

May

Jun

Jul

Aug

Sep

Oct

Nov

Dec

-2.00

With several years of basis
information, a chart can be createdto highlight the strongest, weakest,
average and range of basis for aparticular week of the calendar year.

-4.00
Average

Strongest

WeakestSource: CME Group and USDA

Live Cattle Monthly Basis (Cash-Futures)Live Cattle Monthly Basis (Cash-Futures)

Jan
Mar
May
Jul
Sep
Nov
Jan
Mar
May
Jul
Sep
Nov
Jan
Mar
May
Jul
Sep
Nov
Jan
Mar
May
Jul
Sep
Nov
Jan
Mar
May
Jul
Sep
Nov
Jan
Mar
May
Jul
Sep
Nov
Jan
Mar
May
Jul
Sep
Nov
Jan
Mar
May
Jul
Sep
Nov
Jan
Mar
May
Jul
Sep
Nov
Jan
Mar
May
Jul
Sep

$13.00$12.00$11.00$10.00
$9.00
$8.00
$7.00
$6.00
$5.00
$4.00
$3.00
$2.00
$1.00
$0.00
($1.00)($2.00)($3.00)($4.00)($5.00)($6.00)($7.00)

2008

2009

2010

2011

2012

2013

2014

2015

2016

As stated earlier, knowing what theforward quoted basis is compared
to where the basis is expected tobe during any calendar week of theyear, will help make the decision ofwhich risk management contract andstrategy appears to work best.

2017

Source: CME Group and USDA

Basis data
The format or frequency of basis data collection is a choice. The most important thing is to just get started collecting it.

Basis Summary
From the amount of information devoted to the topic
of basis in this publication, it should be clear how
important this concept is to price risk management. As
such, a good student of basis should have an easier taskof becoming a good student of price risk management.

General Hedging Theory
There are two primary elements to hedging theory:the cash/futures price relationship and the market
positions of the hedge.
18

1.	For a hedge to be effective there has to be a positive
relationship, or correlation, between the hedger’s
local cash market price and a futures market price forthe same or related commodity. If there is a positive
correlation, as one market moves the other market also
moves in the same direction, even though their prices may
not change on a 1 to 1 basis. That change would indicate
a 100% correlation or perfect correlation, but it is usuallyless than this. A general rule of thumb is that 80% or
better correlation should result in an effective hedge.

Livestock Self Study Guide

2.	To be hedged is to have opposite positions in
the cash market and the futures market. That is,
one would be long the cash market and shortfutures, or short the cash market and long futures.
These opposite positions need to be maintained
throughout the life of the hedge.

Hedge Results
The result of a hedge should be the same regardless ofwhich direction the price moves. In a properly executed
hedge, one would experience a loss in one market anda gain in the other, i.e., a loss in the futures market would
be offset by a gain in the cash market and vice versa.
The exception may occur when there is a change in thecorrelation or in other words, when there is a change in basis.

HEDGING INCLUDES CASH + FUTURES
A common misconception about hedging is that the hedge is only the futures market position. Remember that a hedge always
consists of a futures market position and a cash market position. It is the combined result of these two market positions that
determines the result of the hedge.

QUIZ 3
1.	What is Basis?
a. Relationship between two different futurescontract prices
b. Relationship between two different cash market pricesc. Relationship between a cash market price and afutures market priced. Relationship between a margin level and thecommission
2.	In the basis equation, which factor is the same forall locations in the world?

4.	What is the relationship between a cash market
position and a futures market position in a hedge?
a. The positions are identicalb. O pposite of each otherc. T he futures position is always larger than the
cash market positiond. T he futures position is always smaller than the
cash market position
5.	For a hedge to be effective, what is necessary?
a. Integration between the cash and futures market

a. The cash market priceb. S imulation between the cash and futures market

b. The option strike pricec. C orrelation between the cash and futures
market pricesc. The futures market priced. The basis
3.	What happens if a cash market price gains relative
to a futures price over time?

d. Inflation in the economy

Answers are located in the Appendix.

a. Basis strengthens and benefits the long hedgerb. Basis strengthens and benefits the short hedgerc. Basis weakens and benefits the short hedgerd. Doesn’t have an impact on basis

19cmegroup.com/agriculture

CHAPTER 4 SHORT FUTURES HEDGE: PRICERISK MANAGEMENT FOR LIVESTOCK SELLERS
The short futures hedge is one of the most basic pricerisk management strategies for an individual or firm who
has intentions of selling cash (physical) livestock or meatat some point in the future. A potential seller of livestockor livestock products is primarily concerned about
falling prices in their local markets. Other potential shorthedgers would be anyone who is holding inventory andas such, is exposed to the risk of falling prices as it will
negatively impact their inventory value.

Examples of Potential Short Hedgers• Cattle ranchers• Hog producers• Feedlots• Packers holding inventory• Exporters• Food related businesses holding inventory(e.g., restaurants, butchers, food processors)

Concept and Mechanics of the Short
Futures Hedge
The concept of a short futures hedge is to use a futurescontract to manage the risk of falling prices in thehedger’s local cash market at some point in the future.
Price risk management can be used to protect either
short term or long term sales, as well as inventory value.

The mechanics of a short hedge consists of twonecessary features:
1.	The short hedge always consists of two market
positions: one in the livestock futures market and
one in a local cash market. The initial short futures
market position in a short hedge is solely for theprotection against falling cash livestock prices. As
such, the short futures position acts as a temporary
substitute for the eventual cash market sale of theactual livestock or livestock product.
	At all times during the life of a hedge, the futures
market position should be opposite the cash market
position. For a short hedge, the initial cash market
position is long the physical livestock or livestock
product, which they are either producing or own inthe case of inventory. Therefore, the initial futures
position of a short hedge is short futures.
	These market positions of a short hedge are
maintained until the time that the risk of falling
prices no longer exists for that specific cash saletransaction. This occurs when the actual livestock
or inventory is sold or priced in the cash market.
Immediately upon the sale or pricing of the actual
livestock or physical inventory, the futures position
is no longer needed and should be offset by buying
back the initial short futures position.
	If a hedger does not maintain simultaneous
opposite positions in the cash and futures market,
it is no longer considered a hedge. It may even beconsidered to be a speculative transaction.

20

Livestock Self Study Guide

2.	The cash market price and the futures market priceare positively correlated, moving up and down
together. Remember, that although the two markets
move in the same direction, the amount of change
in one market could be different than the other. As
that occurs there would be a change in the basis
over time. The short (selling) hedger is looking foropportunities for their local basis to strengthen by
the time the hedge is closed out.

Short Hedge Results
When combining the two previously discussed featuresof a short hedge, if the risk of falling prices actuallyoccurs, the lower selling price in the cash market should
be offset by a gain in the futures market. If the pricerisk does not occur and prices increase, the higher cash
selling price will be offset by a loss in the futures market
position. Regardless of the price direction, a loss in one
market should be offset by a gain in the other. Wheninitiating a position, the hedger obviously does not know
which market will have a gain and which one will havea loss. However, they should be secure in knowing thatthey have a position in the futures market that should
protect them against falling prices in their local market.

Short hedge example # 1
Falling Hog Prices with Basis Remaining as Expected
DATE

CASH MARKET

FUTURES MARKET

BASIS

March 15

Expected hog price at $70.00/cwt based on
expected September basis of -5.00 (under)
October futures

Short October Lean Hogs/cwt at$75.00- 5.00

September 25

Sell hogs at $65.00/cwt

Buy (offset) October Lean Hogs
at $70.00/cwt- 5.00Results

Lower revenue of $5.00$5.00 gain

No change

Sell cash hogs at
Futures gain

$65.00/cwt+ 5.00Net selling price		

$70.00/cwt

Note: Although the cash market for hogs declined from March to September resulting in lower revenue from the cash sale, the futures market
position resulted in a gain, which offset the lower cash selling price. As such, the short hedger achieved price protection and the expected selling
price of $70.00.
21

cmegroup.com/agriculture

Short hedge example # 2
Rising Prices with Basis Remaining as Expected
DATE

CASH MARKET

FUTURES MARKET

BASIS

March 15

Expected hog price at $70.00/cwt based on expected
September basis of -5.00 (under) October futures

Short October Lean Hogs
at $75.00/cwt- 5.00

September 25

Sell hogs at $73.00/cwt

Buy (offset) October Lean
Hogs at $78.00/cwt- 5.00Results

Higher revenue of $3.00$3.00 loss

No change

Sell cash hogs at
Futures gain		$73.00/cwt- 3.00Net selling price		

$70.00/cwt

Note: Although the cash market for hogs rallied from March to September resulting in higher revenue from the cash sale, the futures
market position resulted in a loss, which offset the higher cash selling price. As such, the short hedger again achieved the expected
selling price of $70.00.

Short hedge example # 3
Falling Prices with Stronger than Expected BasisDATE

CASH MARKET

FUTURES MARKET

BASIS

March 15

Expected hog price at $70.00/cwt based on expected
September basis of -5.00 (under) October futures

Short October Lean Hogs
at $75.00/cwt- 5.00

September 25

Sell hogs at $68.00/cwt

Buy (offset) October Lean
Hogs at $70.00/cwt- 2.00Results

Lower revenue of $2.00$5.00 gain

3.00 basis gain

Sell cash hogs at
Futures gain		$68.00/cwt+ 5.00Net selling price		

$73.00/cwt

Note: As a result of the cash market declining less than the futures market price, the basis improved (strengthened). Although the cash market forhogs declined from March to September resulting in lower revenue from the cash sale, the gain on the futures market position more than offset thelower revenue. Due to a stronger basis at the time of the cash sale, the short hedger received $3.00 more than the expected selling price of $70.00.

22Livestock Self Study Guide

Short hedge example # 4
Rising Prices with Weaker than Expected BasisDATE

CASH MARKET

FUTURES MARKET

BASIS

15-Mar

Expected hog price at $70.00/cwt based on expected
September basis of -5.00 (under) October futures

Short October Lean Hogs
at $75.00/cwt-525-SepSell hogs at $71.00/cwt

Buy (offset) October Lean
Hogs at $77.00/cwt-6Results

Higher revenue of $1.00$2.00 loss

1.00 basis loss

Sell cash hogs at
Futures gain		$71.00/cwt- 2.00Net selling price		

$69.00/cwt

Note: Overall, the basis weakened as a result of the cash market increasing less than the increase in the futures market price. Although the cash
market for hogs rallied from March to September resulting in higher revenue from the cash sale, the loss on the futures market position exceeded
the gain in the cash market. As a result of the weaker basis at the time of the cash sale, the short hedger received $1.00 less than the expected
selling price of $70.00.

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cmegroup.com/agriculture

Highlights of the Short Hedge
Regardless of the price change over time, a loss ineither the cash or futures market is offset by a gain in
the other market, resulting in the same net selling price.
The one key factor which could affect this net outcome
is a change in the basis at the time of the cash market
sale. A short (selling) hedger’s net result will improve
if the basis strengthens, and the net result will beworse if the basis weakens at the time of the cashsale. In addition to the impact of a basis change, theshort hedger needs to subtract the futures brokeragecommission from the net result.

short hedge
A short hedge is the use of two markets (cash and futures)to establish a selling price, and it is this selling price that will
determine the profitability of the business. Although there
may be different nuances to each type of livestock, this key
concept applies to any individual or firm who plans to sellcattle, feeder cattle or hogs.

3.	After a short hedge is initiated, what changes
impact the result of the hedge?
a. Change in the cash market priceb. Change in the futures market pricec. Change in the margin leveld. Change in the basis
4.	If price levels go lower after a short hedge
is initiated, what are the results?
a. Gain in the cash market and gain in the
futures marketb. L oss in the cash market and loss in the
futures marketc. G ain in the cash market and loss in the
futures marketd. L
 oss in the cash market and gain in the
futures market
5.	What will have an impact on the net hedged
selling price?
a. Stronger basis will improve the results of
the hedgeb. B rokerage commission must be subtracted
from the resultsc. Interest costs associated with the shorthedger’s margin account

QUIZ 4
1.

What are the short hedger’s initial positions?
a. Short cash market and long futures market
b. Short cash market and short futures market
c. Long cash market and short futures market
d. Long cash market and long futures market?

2.

What change will benefit a short hedger?
a. Falling prices
b. Rising pricesc. Stronger basis
d. Weaker basis

24

d. A
 ll of the above

Answers are located in the Appendix.

Livestock Self Study Guide

CHAPTER 5 LONG FUTURES HEDGE: PRICERISK MANAGEMENT FOR LIVESTOCK BUYERS
The long futures hedge is one of the most basic pricerisk management strategies for an individual or firm
who has intentions of buying cash (physical) livestockor livestock products at some point in the future. A
potential buyer of livestock or livestock products isprimarily concerned about rising prices in their local
markets, which would have a negative impact on theirprofitability.

Examples of Potential Long Livestock Hedgers• Packers• Feedlots• Importers• Restaurants• Food processors• Livestock producers/feedlots(also potential long feed grain hedgers)

Concept and Mechanics of the Long
Futures Hedge
The concept of a long futures hedge is to use a futurescontract to manage the risk of rising prices in thehedger’s local cash market at some point in the future.
Price risk management can be used to protect either
short term or long term purchases.
The mechanics of a long hedge consists of twonecessary features:	At all times during the life of a long hedge, thefutures market position has to be opposite the cash
market position. For a long hedge, the initial cash
market position is short the physical livestock or
product, which means they do not currently own
it but will need to buy it in the future. Therefore,
the initial futures position of a long hedge is long
futures. As such, the initial long futures position is atemporary substitute for the eventual purchase in the
cash market.
	The market positions of a long hedge are
maintained until the time that the risk of rising prices
no longer exists for that specific cash purchase. That
occurs when the actual livestock or livestock productis bought or priced in the cash market. Immediately
upon the purchase or pricing of the livestock orlivestock product, the futures position is no longer
needed and should be offset by selling back the
initial long futures position.
2.	The cash market price and the futures market priceare positively correlated, moving up and down
together. Again, remember that although the twomarkets move in the same direction, the amount ofchange in one market could be different than theother. As that occurs, there would be a change in thebasis over time. The long (buying) hedger is looking
for opportunities for their local basis to weaken by
the time the hedge is closed out.

1.	The long hedge always consists of two market
positions: one in the livestock futures market
and one in a local cash market. The initial long
futures market position in a long hedge is solely
for protection against rising livestock prices in thehedger’s local market.

25

cmegroup.com/agricultureLong Hedge Results
When combining the two previously discussed features of a long hedge, if the risk of rising prices actually occurs,
the higher purchase price in the cash market should be offset by a gain in the futures market. If the price risk does
not occur and prices actually fall, the loss on the futures market position is offset by a lower cash purchase price.
Regardless of the price direction, a loss in one market should be offset by a gain in the other. When initiating ahedge, it is not known which market will have a gain and which one will have a loss. However, the long hedger
should be secure in knowing that their position in the futures market should provide protection against rising
prices in their local market.

Long hedge example # 1
Rising Feeder Cattle Prices with Basis Remaining as Expected
DATE

CASH MARKET

FUTURES MARKET

BASIS

4-Sep

Expected feeder cattle price at $152.00/cwt based on
expected February basis of + 2.00 (over) March futures

Long March Feeder Cattle
at $150.00/cwt

225-FebBuy feeder cattle at $160.00/cwt

Sell (offset) March Feeder
Cattle at $158.00/cwt

2Results

Higher cost of $8.00$8.00 gain

No change

Sell cash feeder cattle at		
Futures gain			$160.00/cwt- 8.00Net purchase price		$152.00/cwt

Note: Although the cash market for feeder cattle rallied from September to February resulting in higher cash costs, the futures market
position resulted in a gain, which lowered the net cash purchase price. As such, the long hedger achieved price protection and the
expected purchase price of $152.00.

26

Livestock Self Study Guide

Long hedge example # 2
Falling Feeder Cattle Prices with Basis Remaining as Expected
DATE

CASH MARKET

FUTURES MARKET

BASIS

4-Sep

Expected feeder cattle price at $152.00/cwt based on
expected February basis of + 2.00 (over) March futures

Long March Feeder Cattle
at $150.00/cwt

225-FebBuy feeder cattle at $148.00/cwt

Sell March Feeder Cattle at$146.00/cwt

2Results

Lower cost of $4.00$4.00 loss

No change

Buy cash feeder cattle at		
Futures loss			

$148.00/cwt+ 4.00Net purchase price		$152.00/cwt

Note: Although the cash market for feeder cattle declined from September to February resulting in lower cash costs, the futures market
position resulted in a loss, which increased the net cash purchase price. As such, the long hedger again achieved the expected purchaseprice of $152.00.

Long hedge example # 3
Rising Feeder Cattle Prices with Weaker than Expected BasisDATE

CASH MARKET

FUTURES MARKET

BASIS

4-Sep

Expected feeder cattle price at $152.00/cwt based on
expected February basis of + 2.00 (over) March futures

Long March Feeder Cattle
at 150.00/cwt

225-FebBuy feeder cattle at $155.00/cwt

Sell March Feeder Cattle at
156.00/cwt-1Results

Higher cost of $3.00$6.00 gain

3.00 basis gain

Buy cash feeder cattle at		
Futures gain			$155.00/cwt- 6.00Net purchase price		$149.00/cwt

Note: Although the cash market for feeder cattle rallied from September to February resulting in higher cash costs, the futures market
position resulted in a gain, which more than offset the higher cash purchase price. As such, the long hedger improved (lowered) their
expected net purchase price by the amount of the basis improvement (weakening) of 3.00.

27

cmegroup.com/agricultureLong hedge example # 4
Falling Prices with Stronger than Expected BasisDATE

CASH MARKET

FUTURES MARKET

BASIS

4-Sep

Expected feeder cattle price at $152.00/cwt based on
expected February basis of + 2.00 (over) March futures

Long March Feeder Cattle
at 150.00/cwt

225-FebBuy feeder cattle at $148.00/cwt

Sell March Feeder Cattle at
144.00/cwt

4Results

Lower cost of $4.00/cwt$6.00/cwt loss

2.00 basis loss

Buy cash feeder cattle at		
Futures Loss			

$148.00/cwt+ 6.00Net purchase price		

$154.00/cwt

Note: Although the cash market for feeder cattle declined from September to February resulting in lower cash costs, the futures market
position resulted in a greater loss, which more than offset the lower cash purchase price. As such, the long hedger’s net purchase price
was $2.00 greater than expected due to the amount that the basis strengthened at the time of the cash transaction.

Highlights of the Long Hedge
Regardless of the price change over time, a loss ineither the cash or futures market is offset by a gain in
the other market, resulting in the same net buying price.
The one key factor which could affect this net outcome
is a change in the basis at the time of the cash market
purchase. A long (buying) hedger’s net result will improve
if the basis weakens, and the net result will be worse if
the basis strengthens at the time of the cash purchase.
In addition to the impact of a change in the basis, thelong hedger must add the futures brokerage commission
to the net purchase price.

28

long hedge
A long hedge is the use of two markets to establish apurchase price, and it is this price that will determine
the profitability of the business. Although there may bedifferent nuances to each type of livestock, this basic andkey concept applies to any individual or firm who plans tobuy cattle, feeder cattle or hogs.

Livestock Self Study Guide

QUIZ 5
1. What type of potential hedger is a livestock producer?
a. Only a short hedgerb. A short hedger for the sale of their livestock
c. A long hedger for the purchase of their feedd. Both B and C
2. 	What will benefit a long livestock hedge after
it is initiated?
a. Weaker basis
b. Stronger basisc. Higher prices
d. Lower prices
3.	Who are potential long livestock hedgers?
a. Restaurants
b. Packers
c. Feedlots who buy feeder stock
d. All the above
4. 	Which market has an impact on the final net resultof a long futures hedge?
a. Cash market
b. Futures market
c. Option market
d. Both A and B
5. 	What market condition is necessary for aneffective long hedge?
a. Simulation between the cash and futures market
b. Integration between the cash and futures market
c. Variation between the cash and futures market
d. Correlation between the cash and futures market

Answers are located at the end of this publication in the Appendix.

29

cmegroup.com/agriculture

CHAPTER 6 OVERVIEW OF THE LIVESTOCKOPTIONS MARKETThe extensive array of livestock risk management tools
offered by the CME includes options on Live Cattle,
Feeder Cattle and Lean Hog futures. These option
contracts can be utilized in a variety of ways to provide
protection and opportunity.
For example, a livestock producer using options could
obtain downside protection similar to a short futures
position, but unlike a short futures hedge, they also
retain the opportunity to benefit from higher prices.
Conversely, a livestock buyer could obtain upside priceprotection much like a long futures hedge, but unlike along futures hedge, they may still have the opportunity
to benefit from lower prices.

This is possible because of the foundation of an option
contract: options convey rights and not obligations.
The rights in an option are either to buy (call option) or
to sell (put option) the underlying futures contract. For
every option that is traded, there is a buyer and a seller.
The option buyer pays the premium (cost of the option)
to receive the rights within the specific option. Since anoption buyer has rights and no market obligations toperform, they do not have performance bond/margin
requirements with that position. On the other hand, theoption seller who received the premium for selling thoserights has a market obligation to fulfill them and as such,they will have performance bond/margin requirements.
In order to use livestock options as effective risk
management tools, it is imperative to understand the uniqueterminology, concepts and pricing of these instruments.

CME Livestock Option Contract Specifications
Livestock Option Contract Highlights
Live Cattle Options

Feeder Cattle Options

Lean Hog Option

Underlying Contract

40,000 pound (lb.)
CME Live Cattle futures

50,000 pound (lb.)
CME Feeder Cattle futures

40,000 pound (lb.)
CME Lean Hog futures

Pricing unit (premium)Cents per pound

Cents per pound

Cents per pound

Tick size (minimum
premium fluctuation)

Full tick: $0.00025/lb.
Half tick: $0.000125/lb.

Full tick: $0.00025/lb.
Half tick: $0.000125/lb.

Full tick: $0.00025/lb.
Half tick: $0.000125/lb.

Strike Price Intervals$0.02/lb. for all months plus $0.01/lb. fornearest three months$0.02/lb. for all months plus
$0.01/lb. for nearest three months
plus $0.005/lb. for spot mo.

$0.02/lb. for all months plus
$0.01/lb. for nearest three months

Contract Months

Standard: Feb, Apr, Jun, Aug, Oct, Dec
Serial: Jan, Mar, May, Jul, Sep, Nov

Standard: Jan, Mar, Apr, May,
Aug, Sep, Oct, Nov

Standard: Feb, Apr, May, Jun, Jul,
Aug, Oct, Dec

Ticker Symbol

CME Globex: LE
Trading Floor: CK/PK

CME Globex: GF
Trading Floor: KF/JF

CME Globex: HE
Trading Floor: CH/PH

Trading Hours

CME Globex: Monday-Friday: 9:05 am to 1:05 pm Central Time
Trading Floor: Monday-Friday: 9:05 am to 1:05 pm Central TimeFor additional Livestock option contract specifications, visit cmegroup.com/agriculture30

Livestock Self Study Guide

Option Terminology Concepts
An option is a legally binding contract that provides
a right, but not an obligation to either buy or sell anunderlying commodity at a specific price within a
specific time period in exchange for a premium.

Calls versus Puts
There are two types of options: call options and put
options. Livestock call options contain the right to buy
a specific livestock futures contract at a specificprice prior to a specific expiration date. Livestock
put options contain the right to sell a specific livestock
futures contract at a specific price prior to a specificexpiration date.
It is important to note that calls and puts are twocompletely separate and distinct option contracts.
They are not offsetting contract positions.

Call Option Positions
For every call option, there is a call buyer and a callseller; just as with futures, one could elect to initially go
long (buy) or short (sell) a call option. A long call option
is the opposite and offsetting position to a short call
option of the same type.
The call option buyer pays a premium and receives theright to buy the underlying livestock futures contract.
Since the call option buyer has the right to take a long
futures position and not an obligation, they do nothave to post or maintain margin or a performancebond. They are only required to pay the call option
premium up front. A call option buyer is also referred
to as a “holder”, meaning they are holding the rights tobuy the underlying livestock futures contract.

The call option seller is also known as either a “writer”
or “grantor,” as they grant the rights to buy and arethen obligated to sell the underlying livestock futurescontract. The call option seller receives the premiumin exchange for granting the rights to the buyer. They
have an obligation to sell the underlying livestock
futures contract to the call option buyer, if and when
the call option buyer decides to “exercise” the call
option, i.e., to use the rights conveyed in the option.
The call option seller must post and maintain aperformance bond or margin account to ensure thatthe rights will be fulfilled.
A call option is offset by taking the opposite positionin an identical call option. In other words, if a call is
initially bought and later an identical call is sold, theoption positions are offset and the initial option buyer
is out of the market. Likewise, if a call is initially soldand later an identical call is purchased, the two option
positions are offset and the initial option seller is out of
the market.
Note that only the call option buyer can exercise (use) the right to buy
livestock futures. The call option seller is obligated to fulfill that right
any time the buyer chooses to exercise it.

Put Option Positions
For every put option, there is a put buyer and a put
seller. A long (buy) put option position is the opposite
and offsetting position to a short (sell) put option.
The put option buyer pays a premium and receives theright to sell the underlying livestock futures contract.
Since the put option buyer has the right to take ashort futures position and not an obligation, they do
not have to post or maintain performance bond or
margin. They are only required to pay the put option
premium up front.
A put option buyer is also referred to as a “holder”,
meaning they are holding the rights to sell theunderlying livestock futures contract.

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The put option seller is also known as the “writer”
or “grantor,” as they grant the rights to sell and are
obligated to sell the underlying livestock futurescontract. The put option seller receives the option
premium in exchange for granting the rights to thebuyer. The put option seller has an obligation to buy
the underlying livestock futures contract if and when
the put option buyer decides to “exercise” the put
option, i.e., use the rights conveyed in the option. To
ensure that the rights will be fulfilled, the put option
seller must post and maintain a performance bond or
margin account.

A put option is offset by trading the opposite positionin an identical put option. In other words, if a put
option is initially bought, and later an identical put issold, the option positions are offset and the initial put
option buyer is out of the market. Likewise, if a put
option is initially sold and later an identical put option
is bought, the two option positions are offset and theinitial put option seller is out of the market.
Again, note that only the put option buyer can exercise (use) the rightto sell livestock futures. The put option seller is obligated to fulfill thatright any time the buyer chooses to exercise it.

Summary of Option Positions
July 86 Lean Hog Call Options

April 110 Live Cattle Put Options

Long (Buy) Option Position (Pays premium)

Right to buy July Lean Hog futures at$86.00/cwt.

Right to sell April Live Cattle futures at$110.00/cwt.

Short (Sell) Option Position (Receives premium)Obligation to sell July Lean Hog futures at$86.00/cwt.

Obligation to buy April Live Cattle futures
at $110.00/cwt.

Strike Price
Important note for selling options
Due to the amount of risk associated with selling either
call options or put options, many option sellers will look tominimize this risk by taking another position in a different but
related futures, option or cash market contract. Dependingon the trader’s objectives, the option seller could be either
a hedger with specific risk management objectives, or a
speculator with specific opinions on market movement.

The option strike price is the price at which theunderlying futures position will be assumed if theoption is exercised, i.e., the price of the long futures
position in the case of a call, or a short futures positionin the case of a put. Strike prices are also referred toas exercise prices. Option traders will choose froman initial array of option strike prices in intervals
established by the Exchange for each livestock
commodity. As the underlying livestock futures market
moves in either direction, the Exchange will makeadditional strike prices available for trading.
Note that each strike price represents a different option contract. Oncean option is either bought or sold, the chosen strike price is a specificfixed part of that option contract.

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Underlying Contract
A livestock option’s underlying contract is therespective livestock futures contract of a specificcontract month. For example, the underlying contract
to a February Live Cattle option (call or put) is a
February Live Cattle futures contract. The underlying
contract to a September Feeder Cattle option (call orput) is a September Feeder Cattle futures contract.
Standard options contract months are listed tocorrespond to the same months as the underlying
futures. Standard options become available for tradingat least one day following the first day of trading of theunderlying futures. As such, some livestock options will
be available months or even years in advance of their
expiration.

Serial options are listed for the months which are
not a part of the standard livestock futures contract
cycle, and usually have a lifespan of 45 to 60 days until
to expiration. Since serial options have months notincluded in the standard livestock futures cycle, theirunderlying futures contract is the one closest, but notprior to, the serial option month.
The primary advantage to serial options is that theyusually trade at a lower premium due to their shorter
duration, which means the cost of short term risk
management is relatively less. This will become clearer
in the discussion on option premium.

In addition, other options with shorter life cycles
are available for trading. They are used by livestock
hedgers who want short-term protection at a relatively
lower cost, or by a speculator interested in short term
opportunities.

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Option Expiration
Call and put option rights have an expiration date,after which the option can no longer be exercisedby the option buyer and the value of those expired
options is zero.

Livestock Option Expiration Information
Live Cattle options expire on the first Friday of the option
contract month at 1:00 p.m. Chicago time. Feeder Cattle
options expire on the last Thursday of the option contract
month at 12:00 p.m. Chicago time, unless it is an Exchange
holiday. Lean Hog options expire on the 10th business dayof the option contract month at 12:00 p.m. Chicago time.
Note, for a livestock hedger using grain and oilseed options
to manage the price risk of their feed, it is important to knowthat the grain and oilseed options normally expire on thethird Friday of the calendar month prior to the option month.

Option Pricing
Premium is one of the most important concepts inoption trading. The premium is the price or cost of
the option paid by the option buyer and received by
the option seller. Premiums are also referred to as thecurrent value of the rights in an option.
Although the initial option premium is fixed as a costto the option buyer, the price or value of the option
will fluctuate throughout its life. In other words, whenan option is bought, the initial premium paid is the
maximum cost of that option strategy to the buyer. If
an option is sold, the initial premium collected is the
maximum gain on that strategy to the seller.
Premium is the only term of an option contract that is
negotiated in the marketplace, on CME Globex. Option
premiums are not set by the Exchange.

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Although the option premium is quoted as a single
price, it can be broken down into two components:
Intrinsic Value and Time Value:
Option Premium = Intrinsic Value + Time Value

So what are the major factors that could impact andchange the premium throughout the life of an option?
Let’s review the market factors that affect these two
key components.

Intrinsic Value
Intrinsic value is the value of an option if it is exercised
immediately. Intrinsic value is determined by the
relationship between the option strike price and thecurrent underlying futures price.
A call option has intrinsic value if the strike price islower than the underlying futures price. In other words,
it gives the holder the right to buy (or go long) futures
at a price that is below the current futures price. The
intrinsic value is the difference between the strike priceand the underlying futures price. For example, if an
August Feeder Cattle call option has a strike price of120 (i.e., the right to buy August Feeder Cattle futures
at $120/cwt) and the underlying August Feeder Cattle
futures contract is currently trading at 122, the call
option’s intrinsic value is $2.00/cwt.
A put option will have intrinsic value if the put strikeprice is higher than the underlying futures price. In
other words, it gives the holder the right to sell (or go
short) the underlying futures at a price that is above
the current underlying futures price. For example, if an
August Feeder Cattle put option has a strike price of120, i.e., contains the right to sell August Feeder Cattle
futures at 120) and the underlying August Feeder Cattle
futures contract is currently trading at 115, the intrinsic
value of that put option is $5.00/cwt.

Livestock Self Study Guide

Option Classifications
An option may be classified in one of three ways at any
point in its life, based on the relationship between the
strike price (a fixed element of the option) and the current
underlying futures contract price (a variable element).
In-the-Money options are options that have intrinsic
value. A call option is in-the-money when the strikeprice is below the current futures price, and a put
option is in-the-money when the strike price is above
the current underlying futures price.

Out-of the-Money options also have no immediate
intrinsic value. A call option is out-of-the-money when
the strike price is above the current underlying futures,
and a put option is out-of the-money when the strikeprice is below the current underlying futures.
Note that option classifications apply to the current time period.
In other words, as the underlying futures price changes, the option
classification may change as well, i.e., move from out-of the-money to
at- or in-the-money, and vice versa.

At-the-Money options are options whose strike priceis identical or close to the underlying futures price. Atthe-money options have no intrinsic value—this applies
to both calls and puts.
Option Classifications
Call Option

Put Option

In-the-Money

Call Strike Price < Futures Price

Put Strike Price > Futures PriceAt-the-Money

Call Strike Price = Futures Price

Put Strike Price = Futures Price

Out-of the-Money

Call Strike Price > Futures Price

Put Strike Price < Futures Price

Time Value
The option’s time value is simply the option premium
minus the intrinsic value:
Time Value = Option Premium – Intrinsic Value

Mathematically, calculating intrinsic or time value isrelatively simple. However, determining what affects anoption’s time value is a little more complex. Time value
is impacted by time remaining to expiration, volatility,
and interest rates. Time to expiration and volatility are
the two most dominating factors.
Time, or the number of days to expiration, is the obvious
factor that impacts time value. Everything else
remaining equal, the greater the amount of time left in
the life of an option, thegreater the time value portion of the premium. “Timedecay” is the decline in time value as there are fewerdays remaining until option expiration. Time value
decay occurs at an increasing rate as expiration
approaches. This works against option buyers and infavor of option sellers.

Time value and option premium
Generally speaking, the premiums associated withstandard, serial and weekly options are heavily affected by
the option’s time value. Standard options usually have thelongest lifespan, followed by serial options and then weekly
options. As such, serial and weekly options are usually lower
cost alternatives to managing short term livestock pricerisk. Their shorter lifespans mean lower time value, resulting
in lower premiums.

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Volatility is the other major factor that impacts anoption’s time value. All else remaining equal, thegreater the volatility of the underlying market, thegreater the option time value.
Note that time value depreciates at an increasing rate throughout thelife of an option, and equals zero at option expiration. If the option has
any value at expiration, it is all intrinsic value.

Time value
Days to Expiration

0

Option Premium Movement
Call option and put option premiums react differently
when the underlying futures contract price changes.
Call option premiums have a direct relationship withchanges in the underlying futures contract price. As
such, call premiums should increase as the underlying
futures contract price increases and should decrease as
the underlying futures contract price decreases. In otherwords, the rights to buy at the call option strike priceshould become more valuable as the underlying futurescontract price moves higher, and decline in value as theunderlying futures contract price moves lower.
Conversely, put option premiums have an inverse
relationship with changes in the underlying futurescontract price. As such, put premiums should increaseas the underlying futures price decreases and decline
as the underlying futures price increases. In otherwords, the rights to sell at the put option strike priceshould become more valuable as the underlying futurescontract price moves lower, and decline in value as theunderlying futures contract price moves higher.
Option Premium Movement
Call Options

put option

As futures pricedeclines

Call premium declines

Put premiumincreases

As futures priceincreases

Call premium increases

Put premium
decreases

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A more advanced study of option pricing would include
the “Greeks.” Option pricing models, such as BlackScholes, have been developed to calculate theoretical
option premiums, and “Greeks” are byproducts of thosemodels, measuring the sensitivity of option prices tovarious additional factors.
For the purposes of the livestock hedger, the main
Greek factor to take into consideration is the options“Delta,” which is the change in an option premium
for a given change in the underlying futures price. It
is often referred to as the hedge ratio, as it indicates
how many options are needed at any point in time tooffset the risk of a price change in the underlying cash
commodity or futures.
Other Greek factors are:
1. Vega: option premium sensitivity to a change
in volatility
2. Theta: the sensitivity of option premium totime decay
3. Gamma: the sensitivity of a change in option
premium due to a change in Delta
Although a thorough working knowledge of the Greeks
is not necessary to use livestock options as an effective
price risk management tool, it may be helpful to beaware of some market factors that other option traderstake into consideration.

Premium
Remember that premium is the most important option
element that impacts the use, choice and profitabilityof trading options for livestock price risk management.
Option buyers pay the premium and option sellers receive
the premium.

Livestock Self Study Guide

Livestock Option Quotations
Livestock futures and option contracts are quoted inpounds, which can be easily converted to hundredweight,
the common industry practice. For example, Live Cattle
and Lean Hogs are 40,000 pound contracts, which isequivalent to 400/cwt. Feeder Cattle are 50,000 poundcontracts, which is equivalent to 500 cwt.
As such, option pricing can be referenced in either
cents per pound, or dollars per hundred pounds, ordollars per contract.
Examples of livestock futures and option pricing:• Lean Hog futures at 89.00 is $0.89/lb or $89.00/cwt• Live Cattle option strike price of 110 is $1.10/lb
or $110/cwt• Feeder Cattle option premium of 1.85 is$925/contract[(1.85 x 50,000 lbs = 92500 cents) /100 = $925]

Where Can I Find Option Premiums?
Premiums for livestock options can be acquired from avariety of sources including:
1. The CME Group website at cmegroup.com
2. Commodity brokers
3. Quote vendors
4. Newspapers

QUIZ 6
1. What is conveyed in a livestock option contract?
a. Right to either buy or sell an underlying livestock
futures contract

2. What do you have if you buy a Live Cattle call option?
a. Obligation to sell a Live Cattle futures contract
b. Obligation to buy a Live Cattle futures contractc. Right to buy a specific Live Cattle futures contractd. Right to sell a specific Live Cattle futures contract
3. If you buy a Lean Hog put option, what is the cost ofthese rights?
a. Strike priceb. Futures pricec. Commissiond. Premium
4. What is a livestock option’s strike price?
a. A component of an option contract that doesn’tchangeb. P
 rice at which you have the rights to buy (call)or sell (put)c. A
 variety of price levels at which you have tochoose fromd. All of the above
5. What is the relationship between livestock option
premiums and futures price movement?
a. Call premiums move in the same direction as
futures prices and put premiums move in the
opposite direction as futures pricesb. C all and put premiums move in the same
direction as futures pricesc. C all and put premiums move in the opposite
direction as futures prices
d. T here isn’t any relationship between livestock
option premiums and livestock futures prices

Answers are located at the end of this publication in the Appendix.

b. Right to either buy or sell livestock in a local
cash marketc. Obligation to either buy or sell livestock futuresd. Obligation to either buy or sell livestock in a
local cash market

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CHAPTER 7 OPTION STRATEGIES FORLIVESTOCK BUYERS
A buyer of physical livestock or livestock products
will be impacted negatively should market prices
rally. The earlier chapters of this publication covered
the use of a futures contract to hedge or lock in apurchase price, thereby eliminating the risk of higher
prices. However, the long futures strategy does notallow the buyer to benefit from more favorable prices
should the market decline.
Some livestock option risk management strategies
offer price protection similar to the long futures hedge
but unlike the futures hedge, buyers will also be able
to benefit from lower market prices. A key benefit ofincluding livestock options is the flexibility they offer
to price risk management plans. By using options,futures, and cash market alternatives either alone or in
combination, the long hedger can eliminate, minimize
or adjust their price risk exposure to a level they are
comfortable with.
There are two primary option strategies for the
livestock buying hedger that highlight the benefits
and flexibility of using livestock options: the Long
Call option strategy and the Long Call/Short Put
Combination strategy.

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Long Call: Establishing a “Maximum”
Purchase Price
The long call strategy provides both protection against
upside market risk and the opportunity to buy at alower price if the markets decline. Hence, the long call
option strategy will establish a maximum purchaseprice without limiting the downside potential.
The buying hedger can choose from a multitude ofoption strike prices, which provide different levels ofrisk management at varying costs (premiums). In otherwords, each different strike price represents a different
call option and therefore will establish a different
maximum purchase price.
So why don’t all livestock buying hedgers use options
rather than futures? It comes down to one key elementof the option markets: the premium.

Long Call Maximum Purchase Price Equation
The premium of the long call needs to be factored
into the results of the option strategy. Also, because
the call option is being used to protect a cash market
purchase, the equation must also include the basis inaddition to the futures commission.

Livestock Self Study Guide

Expected Maximum Purchase Price =Call Strike Price + Call Premium + Expected Basis + Brokerage Commission

Call strike prices and option premium
Remember that choosing a different strike price will result in a different option cost and therefore a different strategy result. The
following example shows how different strike prices can impact the net purchase price, using an expected basis of + 5.00 (over)the futures. Commission is not included in this example.
June Live Cattle futures @ 124
120 (call strike)+ 10.45 (premium)
124 (call strike)+ 7.05 (premium)
130 (call strike)+ 3.15 (premium)
136 (call strike)+ 0.95 (premium)+5.00 (expected basis)+5.00 (expected basis)+5.00 (expected basis)+5.00 (expected basis)= $135.45/cwt= $136.05/cwt= $138.15/cwt= $141.95/cwt

The lower the call strike price, the higher the premium and the lower the maximum purchase price. However, if market prices
decline, the higher strike price option which costs the least will yield the best net price for the buying hedger.

Long Call Strategy: Advantages

Long Call Strategy Example• Risk is limited to the cost of the premium paid forthe option

A cattle buyer decides to hedge against higher prices
by purchasing Live Cattle call options.

• Protection against higher purchasing price levels

Initial Market Conditions:• Opportunity to buy at lower prices remains• Weaker basis at the time of the livestock purchasewill lower the effective buying price• No margin requirements• August Live Cattle futures are currently at $130.00/cwt.
• August 130 Live Cattle call option is trading at apremium of $3.15/cwt• Expected local cash basis in late July is +5.00/cwt
over the August futures• Variety of strike prices offering different levels of protection• Hedger retains the flexibility to choose the cash
market supplier of livestock and/or livestock productsLong Call Strategy: Disadvantages• Must pay the full amount of the call option premium
when the position is initiated• Stronger basis at the time of the livestock purchasewill increase the effective purchase price• Brokerage commission must be paid
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The following are three different scenarios that could occur when the cash livestock is purchased:
August live
cattle futures

Basis

Cash price

130 Call option valueLong call gain/loss

Purchase price = cash price–/+ option gain/ loss

120

5$125.00

0 (expires worthless)$3.15/Max. loss is premium paid

$128.151305$135.00

0 (expires worthless)$3.15/ Max. loss is premium paid

$138.15140

5$145.00$10$6.85 gain ($10- 3.15)$138.15

Example Notes:
1.	As the risk of higher futures prices occurs, the cash
purchase price will also be higher but the gain on
the long call option will offset the increase in the
cash market. Therefore, the net purchase in a risingmarket is capped at a maximum level.
2.	If the market moves lower, the cash purchase pricewill be lower and the loss on the long call option iscapped at the premium paid. Therefore, the buying
hedger has the opportunity to improve their effective
cash purchase price. Note that in this situation thebuying hedger using a long call option will actually“lose” money on the option, while benefitting from abetter (lower) net purchase price. It is important toremember that the effective net purchase price isgoing to determine the profitability of the livestock
operation, and not whether there was a gain or loss
on the option position.
3.	Another factor that could impact the results of thelong call option strategy is if the basis is different
than expected at the time of the cash market
purchase. If it is weaker (e.g., +3.00) the net purchaseprice will be lower and if it is stronger (e.g., 8.00, thenet purchase price will be higher.
4.	The long call option strategy also allows the buying
hedger to choose the cash market supplier, which isusually the cash market participant offering the best
cash price, or in other words, the best basis.

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Long Call/Short Put Combination –Establishing a Purchase Price Range
There could be a variety of reasons why a livestockbuyer would want to establish a purchase price range
by simultaneously buying a call option and selling a put
option. The most obvious reason is that this strategy
provides yet another alternative to manage the risk ofhigher prices in the local cash market. Another reason
is that the premium collected by selling the put option
effectively lowers the cost of the upside protection
provided by purchasing a call option. However, selling
the put option not only lowers the maximum purchaseprice set by the call, it also establishes a minimum (orfloor) purchase price. In other words, the opportunity
for a lower purchase price is limited with the sale of theput option. As such, buying hedgers will usually choose
to sell an out-of-the money put option.
The difference between the call strike price and the put
strike price will determine the purchase price range.
There are many call and put option strike prices thata buying hedger can choose from, allowing them toeffectively determine the parameters of their buying
price range.

Livestock Self Study Guide

Long Call/Short Put Combination: Purchase
Price Range Calculations

Long Call/Short Put Combination
Strategy: Advantages

Unlike the long futures or long call option strategies
that each require a single calculation, the Long
Call/Short Put Combination strategy requires two
calculations: one determines the maximum (ceiling)price of the range and the other determines theminimum (floor) price. The call premium paid and theput premium collected are factored into the results ofthe strategy. Also, because the call and put options
are being used to protect a cash market purchase, thecalculation must also include the basis in addition to
the brokerage commission.

•	Put premium received reduces cost of price protection

Long Call/Short Put Combination:
Expected Maximum Purchase Price = Call Strike Price+ Call Premium – Put Premium + Expected Basis+ Brokerage Commission•	Retain some opportunity for lower purchase prices•	Weaker basis at the time of the livestock purchasewill lower the effective buying price•	No margin on the call option•	Variety of strike prices offers different purchaseprice ranges•	Hedger retains the flexibility to choose the cash
market supplier of livestock and/or livestock productsLong Call/Short Put Combination
Strategy: Disadvantages•	Must pay the full amount of the call option when theposition is initiated•	Establishes a minimum purchase priceLong Call/Short Put Combination:
Expected Minimum Purchase Price = Put Strike Price+ Call Premium – Put Premium + Expected Basis+ Brokerage Commission•	Margin required on the short put option•	Short put option may be exercised earlier than expected•	Stronger basis at the time of the livestock purchasewill increase the effective purchase priceLong call/short put strikes
Options with different strike prices will also havedifferent premiums, which will result in different purchaseprice ranges. Although the objective of selling a put incombination with the call option is to lower the cost of
the upside market risk, the short put also establishes aminimum purchase price. In other words, the long hedger’s
downside opportunity is limited.

•	Brokerage commission must be paid for the calland put option

Long Call/Short Put Combination
Strategy Example
A cattle buyer decides to hedge against higher prices
and establish a purchase price range by buying Live
Cattle call options and selling Live Cattle put options.

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Initial Market Conditions:• June Live Cattle futures are currently at $130.00/cwt.
• June 130 Live Cattle call option is trading at a premium of $3.15/cwt• June 124 Live Cattle put option is trading at a premium of $1.35/cwt• Expected local cash basis in late May is +5.00/cwt over the May futures
The following are three different scenarios that could occur when the cash livestock is purchased:
June live
cattle futures

Basis

Cash
price

130 Call option value
124 put option valueLong call result, Short put result,and Net option result

Purchase price = cash price–/+ option gain/ loss

120

+5.00

$125.00

Call Value = $0
Put Value = $4

Long Call: $3.15 loss
Short Put: $2.65 loss
Net Result: $5.80 loss

$130.80

130

+5.00

$135.00

Call Value = $0
Put Value = $0

Long Call: $3.15 loss
Short Put: $1.35 gain
Net Result: $1.80 loss

$136.80

140

+5.00

$145.00

Call Value = $10
Put Value = $0

Long Call: $6.85 gain
Short Put: $1.35 gain
Net Result: $8.20 gain

$136.80

Example Notes:
1.	As the risk of higher futures market prices occurs,
the cash purchase price will also be higher, but thegain on the long call option and the short put option
will offset the increase in the cash market. Therefore,
the net purchase price in a rising market is capped
at a maximum level. This is a lower maximum pricelevel than that of the earlier Long Call strategy; theamount of premium collected for also selling the put
is the difference in the lower maximum price.
2.	If the market moves lower, the cash purchase pricewill be lower. However, the hedger will experience a
maximum loss of the premium paid on the long callcomponent of the strategy, and increasing losses on
the short put option component. Therefore, unlike
the Long Call strategy, the opportunity for a lower
net purchase price in a falling market is limited
because of the short option position.

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3.	The effective price range is determined by the differencein the call and put option strike prices. In the above
example, the price range of $6 was determined by thedifference in the call strike price (130) and the put strikeprice (124). Depending on the risk level a long hedger iswilling to assume, the purchase price range established bythis strategy could vary by choosing different strike prices.
4.	Another factor that could impact the results of theLong Call/Short Put Combination strategy is if thebasis is different than expected at the time of the
cash market purchase. If it is weaker (e.g., +3.00) thenet purchase price will be lower and if it is stronger(e.g., 8.00), the net purchase price will be higher. Also,
the scenarios assumed there is no time value left at
the expiration of the strategy. If there is time value
remaining, it will impact the effective purchase price.
5.	The Long Call/Short Put Combination strategy also
allows the buying hedger to choose the cash market
supplier, which is usually the one offering the best cash
price, or in other words, the best (weakest) basis.

Livestock Self Study Guide

Long Hedger Highlights
This booklet has illustrated three different ways that alivestock or livestock product buyer can use futures or
options to manage the risk of higher market prices.
•	The Long Futures strategy establishes a “purchaseprice level” regardless of whether the market risk
occurs (higher prices) or does not occur (lower prices).
•	The Long Call strategy establishes a “maximum
purchase price level” which provides protection if themarket risk occurs, but also the opportunity for alower price if the market declines.
•	The Long Call/Short Put Combination strategy
establishes a purchase price “range”, which isdetermined by the difference in the call and put
strike prices.
These three strategies are just a few of the numerous
alternatives that are available to manage the livestockbuyer’s price risk by using futures, options andcombinations of contracts. They provide the livestockbuying hedger with the flexibility to adjust their market
risk exposure to a level that they are willing to assume.
A livestock buyer may want to contact their broker,
market advisor or state livestock marketing specialist
to discuss additional strategies to manage their risk.

2.	What is a basic option position for a buyer oflivestock?
a. Long put option
b. Short call option
c. Long call option
d. Short futures
3.	What combination of option positions establishes
a livestock buying range?
a. Long call and long put
b. Short call and long put
c. Long call and short put
d. Short call and short put
4.	What are the benefits of a long call strategy forlivestock buyers?
a. No margin requirements
b. Protection against higher prices
c. Opportunity if prices move lower
d. All of the above
5.	What can impact the final results of a long callstrategy for a livestock buying hedger?
a. A change in the basis
b. A change in the underlying futures pricec. Commission on the option
d. All the above

QUIZ 7

Answers are located in the Appendix.

1.	What market risks does a buyer of livestock face?
a. Lower prices and weaker basis
b. Higher prices and stronger basisc. Higher prices and weaker basis
d. Lower prices and stronger basis

43cmegroup.com/agriculture

CHAPTER 8 OPTION STRATEGIES FORLIVESTOCK SELLERS
Remember that the selling hedger has downsidemarket risk. That is, the profitability of a livestock orlivestock product seller will be impacted negatively
should market prices fall. The early chapters covered
the use of a futures contract to hedge or lock in aselling price, thereby eliminating the risk of lower prices.
However, the short futures strategy does not allow the
selling hedger to benefit from more favorable prices
should market prices increase.
Livestock options are another tool to manage thedownside price risk associated with selling livestock
and/or livestock products. Some of the option
strategies will provide downside price protection similar
to the short futures hedge but unlike the short futures
hedge, livestock sellers will also be able to benefit fromhigher market prices. A key benefit of adding livestock
options to a portfolio is the flexibility that is added
to price risk management plans. By using options,futures and cash market alternatives either alone or in
combination, the short hedger can eliminate, minimize
or adjust their price risk exposure to a level they are
comfortable with.
Two of the primary option strategies that highlightthe benefits and flexibility of using livestock options
to protect a selling price are the Long Put option, andLong Put/Short Call Combination strategy.

Long Put: Establishing a “Minimum”
Selling Price
Similar to the short futures hedge, a long put option
strategy will provide price protection against lower
prices but unlike the short futures hedge, the longput strategy also provides additional opportunity
for a more favorable selling price should the market
move higher. Hence, the long put option strategy will
establish a minimum selling price while not limiting theupside potential.

44

The selling hedger can choose from a multitude ofput option strike prices, which provide different levelsof risk management at different costs. In other words,
each strike price represents a different put option andtherefore, will establish a different minimum selling price.
So why don’t all livestock selling hedgers use theput option market rather than short futures if theput provides both price protection and opportunity?
Again, it comes down to one key element of the option
markets: premium.

Long Put Minimum Selling Price Equation
The cost of the long put option needs to be factored
into the strategy results. Also, because the put option
is being used to protect a cash market sale, theequation must also include the basis, in addition to thebrokerage commission.

Livestock Self Study Guide

Expected Minimum Selling Price =Put Strike Price - Put Premium + Expected Basis - Brokerage Commission

Put strike prices and option premium
Remember that choosing a different strike price will result in a different option cost and therefore a different result of thestrategy. The following examples shows how different put strike prices can impact the net selling price, using an expected basisof - 6.00 (under). Commission is not included in this example.
May Lean Hog Futures @ 96.00
102 (put strike)– 8.85 (premium)96 (put strike)– 4.90 (premium)90 (put strike)– 2.80 (premium)86 (put strike)– 1.25 (premium)– 6.00 (expected basis)– 6.00 (expected basis)– 6.00 (expected basis)– 6.00 (expected basis)= $87.15/cwt= $85.10/cwt= $81.20/cwt= $78.75/cwt

The higher the put strike price, the higher the premium, but the resulting minimum selling price is also higher. However, shouldmarket prices rally, the lower strike price put option which cost the least will yield the best net selling price for the hedger.

Long Put Strategy: Advantages

Long Put Strategy: Disadvantages•	Risk is limited to the cost of the premium paid forthe option•	Must pay the full amount of the put option premium
when the position is initiated•	Protection against the risk of lower price levels•	Weaker basis at the time of the livestock sale will
lower the effective selling price•	Opportunity for higher prices remains•	Stronger basis at the time of the actual livestock
sale will raise the effective selling price•	Brokerage commission must be paid

Long Put Strategy Example•	No margin requirements

A hog producer decides to hedge against falling prices
by selling Lean Hog put options.

•	Variety of strike prices offering different levelsof protection

Initial Market Conditions:•	Short hedger retains the flexibility to choose the
cash market buyer•	April Lean Hog futures are currently at $96.00/cwt.
•	April 96 Lean Hog put option is trading at apremium of $4.90/cwt•	Expected local cash basis in early April is – 6.00/cwt(under) the April futures45

cmegroup.com/agriculture

The following are three different scenarios that could occur when the cash livestock is sold:
April lean hog
futures

Basis

Cash price

96 Put option valueLong put profit/loss

Selling price = cash price+/– option gain/loss

80-6$74.00$16/cwt$11.10/gain$85.1096-6$90.000 (expires worthless)$4.90/max. loss

$85.10112-6$106.00

0 (expires worthless)$4.90/max. loss

$101.10

Example Notes:
1.	As the risk of lower futures prices occurs, the cash
selling price will also be lower but the gain on the longput option will offset the decline in the cash market.
Therefore, the net sale price in a falling market is set at aminimum level.
2.	If the market moves higher, the cash selling pricewill also be higher and the loss on the long put
option is capped at the premium paid. Therefore, ina rising market the short livestock hedger has theopportunity to improve their effective cash selling
price. Note that in this situation, the selling hedger
using a long put option will actually “lose” money on
the option, while benefitting from a better (higher)
net selling price. It is important to remember that theeffective net selling price (combined results of the
cash market and put option positions) is going todetermine the profitability of the livestock operation,and not whether there was a profit or loss on the put
option position.
3.	Another factor that could impact the results of thelong put option strategy is if the basis is different
than expected at the time of the cash market sale. If
it is stronger (e.g., - 3.00) the net selling price will behigher and if it is weaker (e.g., - 8.00, the net selling
price will be lower.

46

4.	The long put option strategy also allows the selling
hedger to choose the cash market buyer, which isusually the livestock buyer offering the best cash
price, or in other words, the best (strongest) basis.

Long Put/Short Call Combination:
Establishing a Selling Price Range
There could be a variety of reasons why a livestock
selling hedger would want to establish a selling pricerange. The most obvious reason is that the Long
Put/Short Call strategy provides yet another way
to manage the risk of lower prices in the local cash
market, with the premium collected by selling the call
option effectively lowering the cost of the downsideprice risk management provided by purchasing theput. However, by selling the call option, not only is theminimum selling price set by the long put increased,
there is also a maximum (or ceiling) selling priceestablished. In other words, the opportunity for a higher
selling price is limited with the sale of the call option.
As such, selling hedgers will usually choose to sell an
out-of-the money call option.
The difference between the put strike price and the call
strike price will determine the selling price range. There
are many put and call option strike prices that a selling
hedger can choose from, allowing them to effectively
determine the parameters, or width of their selling pricerange. This is another risk management alternative thatprovides flexibility for the short hedger.

Livestock Self Study Guide

Long Put/Short Call Combination: Selling
Price Range Calculations

Long Put/Short Call Combination Strategy:
Advantages

Unlike the short futures or long put option strategy
that each require a single calculation, the Long Put/
Short Call Combination requires two calculations:
one calculation to determine the minimum (floor)
selling price of the range and the other to determine
the maximum (ceiling) selling price. The put premium
paid and the call premium collected are factored into
the results of the strategy. Also, because the call andput options are being used to protect a cash market
purchase, the equation must also include the conceptof basis, in addition to the brokerage commission.

•	Call premium received reduces cost of price protection

Long Put/Short Call Combination:
Expected Minimum Selling Price = Put Strike Price– Put Premium + Call Premium + Expected Basis– Brokerage Commission
Long Put/Short Call Combination:
Expected Maximum Selling Price = Call Strike Price– Put Premium + Call Premium + Expected Basis– Brokerage Commission•	Retain some opportunity for higher selling prices•	Stronger basis at the time of the livestock sale will
increase the effective selling price•	No margin on the long put option position•	Variety of strike prices offer different selling price ranges•	Short hedger retains the flexibility to choose the cash
market livestock buyer

Long Put/Short Call Combination Strategy:
Disadvantages•	Must pay the full amount of the put option premium
when the position is initiated•	Establishes a maximum selling price•	Margin is required on the short call option•	Short call option position may be exercised earlier
than expected•	Weaker basis at the time of the livestock sale will
lower the effective selling priceLong put/short call strikes
Put options with different strike prices will also have different
premiums, which will result in different selling price ranges.
Although the objective of the Short Call in combination with
the Long Put option is to lower the cost of the downsidemarket risk protection, the short call establishes a maximum
selling price. In other words, the short hedger’s upside
opportunity is limited.

•	Brokerage commission must be paid for the call andput option

Long Put/Short Call Combination Strategy
ExampleA hog producer decides to hedge against lower prices
and establish a selling price range by buying Lean Hog
put options and selling Lean Hog call options.

47

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Initial Market Conditions:• April Lean Hog futures are currently at $96.00/cwt.
• April 96 Lean Hog put option is trading at a premium of $4.90/cwt• April 102 Lean Hog call option is trading at a premium of $2.60/cwt• Expected local cash basis in early April is 6.00/cwt under the April futures
The following are three different scenarios for when the cash hogs are sold:
April leanhog futures

Basis

Cash
price

96 Put Option Value/
102 Call Option Value

86.00- 6.00$80.00Put Value = $10
Call Value = $0

Long Put: $5.10 gain
Short Call: $2.60 gain
Net Gain: $7.70$87.70

96.00- 6.00$90.00Put Value = $0
Call Value = $0

Long Put: $4.90 loss
Short Call: $2.60 gain
Net Loss: $2.30$87.70106.00- 6.00$100.00

Put Value = $0
Call Value = $4

Long Put: $4.90 loss
Short Call: $1.40 loss
Net Loss: $6.30$93.70

Example Notes:
1.	As the risk of lower market prices occurs, the cash
sale price will also be lower, but the gain on the Long
Put / Short Call Combination strategy will offset
the lower cash market selling price. Therefore, thenet selling price in a falling market is protected at
a minimum level. This is a higher minimum selling
price than that established by the earlier Long Put
strategy. The amount of premium collected for
selling the call option is the difference in the higher
minimum price.
2.	If the market moves higher, the cash selling pricewill be higher. However, the hedger will experience a
maximum loss of the premium he paid on the long
put component of the strategy, and increasing losseson the short call component. Therefore, unlike theLong Put strategy, the opportunity for a higher net
selling price in a rising market is capped because of
the short call option position.
48

Long Put Results
Short Call Results
Net Result

Selling Price = Cash price+/– Option Gain/Loss

3.	The effective selling price range is determined by thedifference in the put and call option strike prices. In
the example, the price range of $6 was determinedby the difference of the put strike price (96) and thecall strike price (102). Depending on the amount ofrisk a short hedger is willing to assume, the hedger
could adjust the selling price range by choosing
different strike prices.
4.	Another factor that could impact the results of theLong Put / Short Call Combination strategy is if thebasis is different than expected at the time of the
cash market sale. If it is stronger than expected (e.g.,-2.00) the net selling price will be higher and if it is
weaker (e.g., -9.00), the net selling price will be lower.
The scenarios in the example assume there is notime value left at expiration of the options. If thereis time value remaining, it will impact the effective
selling price.

Livestock Self Study Guide

5.	The Long Put / Short Call Combination strategy
also allows the selling hedger to choose the cash
market buyer, who is usually the buyer who bids
the best cash price, or in other words, the best
(strongest) basis.

QUIZ 81.

What market risks does a seller of livestock face?
a. Lower prices and weaker basis

Short Hevtvdger Highlights

b. Higher prices and stronger basis

This booklet has illustrated three different ways a sellerof livestock or livestock products can use futures or
options to manage the risk of lower market prices.

d. Lower prices and stronger basisc. Higher prices and weaker basis

2.	What is a basic option position for a seller of livestock?

• The short futures strategy establishes a “selling pricelevel” regardless if the market risk occurs (lower prices)or does not occur (higher prices).

a. Long put option• The Long Put strategy establishes a “minimum selling
price level” which provides protection if the market riskof lower prices occurs, but also the opportunity for abetter selling price if the market moves higher.

d. Short futures• The Long Put / Short Call Combination strategy
establishes a selling price “range”, which is determinedby the difference in the put and call strike prices.
These three strategies are just a few of the numerous
strategies that are available to manage the selling
hedger’s price risk by using futures, options andcombinations of contracts. These strategies provide thelivestock selling hedger with the flexibility to adjust theirmarket risk exposure to a level that they are willingto assume. A livestock seller may want to contact
their commodity broker, market advisor or their state
livestock marketing specialist to discuss additional
strategies to manage their risk.

b. Short call option
c. Long call option

3.	What combination of option positions establishes
a livestock selling range?
a. Long put and short callb. Short call and short put
c. Long call and short put
d. Long call and long put
4.	What are the benefits of a Long Put strategy forlivestock sellers?
a. No margin requirements
b. Protection against lower prices
c. Opportunity if prices move higher
d. All of the above
5.	What can impact the final results of a Long Put
strategy for a livestock seller?
a. A change in the basis
b. A change in the underlying futures pricec. Commission on the option
d. All the above
Answers are located in the Appendix.

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CHAPTER 9 KEYS TO SUCCESSFUL LIVESTOCKRISK MANAGEMENT
For both livestock buyers and livestock sellers, thefollowing are keys to successful risk management.
1.	Develop a team: When it comes to risk
management, a team approach may work best.
This applies to individual operations, family
operations or corporate entities. Family or
corporate operations may find it easier to follow
this key to success, but an individual can also
develop a team by working with friends or family insimilar situations.
2.	Consult with advisors: Advisors may be especiallyhelpful when a livestock hedger is first getting
started in the futures and options markets. There
are different types of advisors that charge different
fees. These include commodity brokers, commodity
consultants, universities, state livestock marketing
specialists and USDA staff. If a hedger feels they
do not have the time or expertise to devote to theimportant function of risk management, they should
feel comfortable getting professional assistance andguidance from those who specialize in this field.
3.	Learn the alternatives: Whether or not the hedger
consults with an advisor, they should learn about all
the alternatives for managing the risk associatedwith purchasing or selling livestock. Even when
consulting with an advisor, the hedger should makethe final decisions as it is their business that is at risk.
4.	Develop a hedging policy: A hedging policy
could range from a very basic set of rules forthe individual or family livestock operation, to acomplex legal document for a corporate hedging
operation. Regardless, it may be important to havesome form of written document to keep decisions
within a specific set of trading rules.

50

5.	Develop a plan: Whereas a hedging policy is moreor less a permanent document with general rulesof trading, a plan pertains to a specific time period
or for a specific livestock sale or purchase that may
occur in the near future. A written plan will help the
livestock hedger stick to their risk management
goals and objectives. It will include decisions suchas which risk management tool to use, pricing
objectives and timing. A livestock hedger candevelop a different plan for each year, or for eachindividual purchase or sale due to different market
conditions, such as price levels and market volatility.
6.	Get management buy-in: Management approval
comes in different forms depending on the size ofthe operation. It can range from a simple nod of
acceptance by a spouse or other family member,to a signed legal approval on a formal corporate
plan. Regardless, if there are others that are
impacted by the decisions, they should at least
be aware of the risk management plans and sign
off on them at some level. Especially with larger
livestock operations, it is important that others inmanagement are comfortable with the objectives
and the plan to achieve them.
7.	Have the discipline to stay with the plan, but
flexibility to adjust: Depending on changes in themarket environment during the course of a hedging
plan, this key may require a difficult combinationof discipline and flexibility. If there are minorchanges in market conditions that appear to bemoving against the hedger, he needs discipline
to stick with the plan. However, on occasion, due
to major unexpected market conditions, it may
be appropriate to make adjustments to the initialplan. One of the worse things a hedger can do is
to make continuous changes in the plan for every
little market hiccup. This could lead to a negative
situation called being “whipsawed.”

Livestock Self Study Guide

8.	Keep good records: Record keeping is an often
overlooked task requiring a minimal amount oftime, but it is essential to good risk management
for livestock buyers and sellers. It could be as
simple as keeping records on paper, to moreadvanced computer spreadsheets. Hedgers should
keep track of the futures and cash market prices,
as well as their local basis. Additionally, they must
keep track of the risk management strategies
used and the resulting profits and losses. Good
records will assist in tax preparation and future risk
management plans.
9.	Review the results: A thorough analysis of therisk management strategies and overall plan isnecessary to determine what worked, what didn’t
work and most importantly, why? Similar to keeping
good records, reviewing results—both positive
and negative—will help a livestock buyer or seller
become a more effective hedger in the future.
10.	Don’t look back: Simply stated, this means tolearn from past experiences and realize not all
experiences are going to be positive, but not
become fixated on the negative. A livestock
hedger may actually learn more from a negative
experience than a positive one. Remember thateveryone has 20-20 hindsight vision and it is theneasy to look back and complain about what shouldhave been done. However, the successful livestock
hedger will use past experiences to move forward ina positive manner.

QUIZ 9
1.	When may it be a good time for a livestock hedger
to adjust their risk management plan?
a. Neverb. Whenever the market moves slightly against youc. W hen global market conditions change
significantly from initial expectations
d. Always when your advisor tells you to change
2. Who should make the final decisions whendeveloping and executing a risk management plan?
a. Management teamb. Spousec. Advisor
d. You, the hedger
3. What are some valid reasons for keeping good records
a. Tax returns
b. Using historical basis information for future risk
management decisions
c. Identify potential market price trends that could
influence future decisions
d. All the above
4. Why is a written risk management plan important?
a. Makes it more difficult to forget or change at
randomb. The CFTC and Exchange will need a copyc. The Internal Revenue service requires a pland. May be helpful when reviewing and/or defending
the plan to your management
e. Both A and D

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5. What risk management strategies should a good
livestock hedger learn?
a. Futures contract strategies
b. Option contract strategies
c. Cash market alternatives
d. Government programse. All of the above and any other new risk
management methods
Answers are located at the end of this publication in
the Appendix.

52

Livestock Self Study Guide

CHAPTER 10 ADDITIONAL RISKS OF THE
LIVESTOCK HEDGERThis guide focused on how Livestock hedgers canmanage the price risks associated with buying andselling livestock and livestock products. There aremany other risks that a livestock operation is exposed
to, and the same concepts of managing livestock risk
can also be applied to other price risks that these
operations may face.
For livestock producers, another critical price risk
is the cost of feed. As the prices and production ofgrain and oilseed crops are impacted by various
factors, it will in turn affect the cost and profitabilityof producing livestock. CME Group grain and oilseed
products, including corn, wheat, soybean meal andoats futures and options, can be used as feed risk
management tools. The following example provides
a simple illustration.

Feed Hedging Example
A livestock producer plans to buy corn in November tomeet his feed requirements. The current cash market
price in July for corn to be delivered in November is$6.50 per bushel. He is concerned that the cash price
may be much higher when he needs to purchasethe physical corn. To protect against a possible priceincrease, the livestock producer buys December Cornfutures at $6.50 per bushel.

Date

Cash market

Futures market

JulyCash Corn is $6.50 per bushel

Buy December Corn futures at $6.50 per
bushelNovember

Buy cash Corn at $7.00 per bushel

Sell December Corn futures at $7.00 per
bushelChange$.50 per bushel loss$.50 per bushel gain

Results

Buy cash corn
Gain on futures position
Net purchase price

$7.00
- .50
$6.50

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Nearly every livestock business consumes energy, which
could have a major impact on a firm’s bottom line.
At times, the energy markets may be quite volatile.
Regardless of the types of energy consumed--gasoline,
natural gas, heating oil, diesel fuel, crude oil or others-CME Group has a variety of Energy futures and options
products available to help manage these risks.

2.	If a livestock hedger is buying or selling livestock orlivestock products to or from another country, what
are some of the market risks they have?

Depending on the size of the livestock related business,
the financial portfolio or the ability to borrow to fundoperations may be at risk to changing interest rates.
Whether the hedger has short or long term interest
rate exposure, the CME Group financial products, suchas Eurodollars and U.S. Treasury futures and options,can help minimize the risks of fluctuating interest rates.

3.	What impact would higher feed prices and higher
energy prices have on a livestock operation?

If a business is buying or selling livestock or livestock
products outside their own borders, fluctuating foreign
currency values (i.e., FX risk) may also have an impact
on the firm’s bottom line. CME Group FX products canhelp manage these market exposures, including Mexican
Peso, British Pound, Canadian Dollar, Japanese Yen,
Euro Currency, Australian Dollar and many others.
A commodity broker or advisor will be able to advise
livestock hedgers on structuring strategies to address
the various risks they face.

CHAPTER 10 QUIZ
1.	What types of market risk does a Livestock
producer have?
a. Livestock prices
b. Energy costsc. Feed costs
d. Interest rates
e. All of the above

54

a. Livestock prices
b. Foreign Currency Exchange Rates
c. A and B
d. No market risk

a. Lowers profitabilityb. Raises profitabilityc. No impact on profitability
4.	Which of the following is the most basic hedging
strategy to protect from higher feed and energy
costs
a. Long put
b. Short callc. Long futures
d. Short futures
5.	What does a long call do for a livestock hedger
who uses feed and energy?
a. Provides price protection against higher feedand energy costsb. Provides opportunity for lower feed and energy
costs
c. Not a valid strategy for feed and energy
d. A and B

Livestock Self Study Guide

Summary
One of the main objectives of this publication was
to provide a good general understanding of the
futures industry and how livestock futures and option
contracts could be used to protect hedgers against
adverse price moves. However, the primary goal
was to highlight the overall importance of pricerisk management, using whatever alternatives areavailable to manage risk. As such, this booklet should
be used by livestock hedgers as a stepping stone tocontinue their education and training.
CME Group Livestock futures and options markets
offer many benefits for buyers and sellers of livestock
products who are looking to manage their price risk.
These include:•	Variety of products and services to help manage
all aspects of business related risks, including
production, feed, energy, currency and interest rates•	Flexibility to adjust risk exposure to a level of their choice•	Liquidity that provides the hedger with efficient entry
and exit of their market positions•	Transparency of two trading platforms providing
openly available market information•	Regulations that provide orderly trading rules for all
market participants•	Financial integrity of CME Clearing behind alltransactions

AppendixGetting Started
The selection of a Futures Commission Merchant (FCM)or commodity broker to assist with a hedger’s tradingneeds should not be taken lightly. One of the first steps
to take when considering a commodity broker is toensure they are registered with the National Futures
Association (NFA).

There are two general types of brokers: Full Service
and Discount brokers. The difference is in the amountof service beyond trade execution that is offered. If
the hedger is relatively new to risk management, they
may prefer to pay a relatively higher commission fora Full Service broker’s additional trading advice andconsultation. A more experienced trader may prefera Discount broker solely for their execution function,and forego additional consulting services for a
relatively lower commission. Regardless of the type, theexecution of the trades should be similar.
One of the best ways to select a commodity broker
for hedging purposes is word of mouth. Check withneighbors or livestock industry colleagues to get theiropinions or referrals. The “Find a Broker” page on the
CME Group website also provides a list of commodity
brokers and their services.
In addition to brokers, a hedger may also seek theservices of a hedging consultant or advisor. The hedger
must make sure that their broker and/or consultant isfully aware of their business operation and their risk
management objectives.

Additional Resources
There are numerous books and periodicals that
focus on livestock risk management alternatives. The
CME Group website has a considerable amount of
information on the agricultural markets, including pricequotes, market commentary, educational publications,
webinars and tutorials. Other resources are state
livestock marketing specialists, usually found at thestate land grant universities.
Regardless of how information is obtained on the
livestock markets, it is imperative to continue learning
about this invaluable subject of price risk management.

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CHAPTER QUIZ ANSWER KEY
Chapter 1:
1.d 2.c 3.e 4.a 5.c 6.c 7.b 8.c

Chapter 9:
1.c 2.d 3.d 4.e 5.eChapter 2:
1.c 2.a 3.c 4.c 5.d

Chapter 10:
1.e 2. c 3.a 4.c 5.d

Chapter 3:
1.c 2.c 3.b 4.b 5.c

Chapter 4:
1.c 2.c 3.d 4.d 5.dChapter 5:
1.d 2.a 3.d 4.d 5.dChapter 6:
1.a 2.c 3.d 4.d 5.a

Chapter 7:
1.b 2.c 3.c 4.d 5.dChapter 8:
1.a 2.a 3.a 4.d 5.dTo learn more visit cmegroup.com/agriculturecmegroup.com
Neither futures trading nor swaps trading are suitable for all investors, and each involves the risk of loss. Swaps trading should only be undertaken by investors who are Eligible Contract Participants (ECPs)
within the meaning of Section 1a(18) of the Commodity Exchange Act. Futures and swaps each are leveraged investments and, because only a percentage of a contract’s value is required to trade, it is possible
to lose more than the amount of money deposited for either a futures or swaps position. Therefore, traders should only use funds that they can afford to lose without affecting their lifestyles and only a portionof those funds should be devoted to any one trade because traders cannot expect to profit on every trade. All examples discussed are hypothetical situations, used for explanation purposes only, and should
not be considered investment advice or the results of actual market experience.
CME Group, the Globe Logo and CME are trademarks of Chicago Mercantile Exchange Inc. CBOT is a trademark of the Board of Trade of the City of Chicago, Inc. NYMEX is a trademark of New York
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The information within this brochure has been compiled by CME Group for general purposes only. CME Group assumes no responsibility for any errors or omissions. Additionally, all examples in this brochureare hypothetical situations, used for explanation purposes only, and should not be considered investment advice or the results of actual market experience. All matters pertaining to rules and specifications
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