Six Things to Consider When Developing a Price Risk Management Strategy

By Kenny Burdine

Over time, I have probably done more programs focused on price risk management than any other cattle marketing topic. This article will not be focused on specific risk management tools and how they work, but rather will focus on some overarching considerations as cattle producers look at ways to manage price risk. Some of these are based on generally accepted strategies, while others are things that I felt important to share based on my experience working with producers. I often share some of these ideas at the conclusion of my risk management programs, but wanted to briefly walk through a few of them for this article. While they are in no particular order, these are some things that I think producers should understand as they develop their risk management plans. I also think the timing is good as the market is currently offering feeder cattle pricing opportunities that we have not seen in quite some time.

Know what risk management tools are available
For the first 10 years of my career, my price risk management extension programs were almost always focused on futures and options strategies. I would also briefly cover forward contracts, although they tend to be used on a limited basis in Kentucky. As internet sales became more common, I was able to discuss using internet sales with delayed delivery. Over the last 15 years, I have been able to also discuss Livestock Risk Protection (LRP) Insurance, which opened the door for smaller scale operators to better manage price risk. And, recently increased subsidy levels have made LRP much more attractive. There are a lot more price risk management tools available than there used to be and producers need to be familiar with what is available to them. Regardless of the strategy or tool that is used, downside price risk needs to be a consideration in every producer’s marketing plan.

Know how changes in sale price impact profit
Producers need to fully understand the impact that changes in sale price can have on profitability. This may be best illustrated through a backgrounding or stocker illustration. Let’s just say for the sake of argument that after purchasing calves, incurring all expenses, and using futures to estimate an expected sale price, return per head was expected to be $120 per cwt. If the expected sale weight on the cattle were 800 lbs, a drop in expected sale price of $0.15 per lb results in profit going to zero. If the last several years have taught us anything, we have learned that this level of market fluctuation is absolutely possible. This speaks to the importance of doing something to manage that downside price risk. Once those cattle are placed, it is unlikely that anything will have more impact on return than what they eventually sell for.

Fully understand the strategy being used
Price risk management strategies range from very simple to very complex. But, whichever strategy that a producer employs, they need to fully understand its mechanics and potential outcomes. As an example, I have been contracted more than once by a producer asking me how they were getting margin calls after purchasing a put option. After looking over their paperwork, they had actually purchased a put option and simultaneously written (sold) a call option. They were unaware that the written call was a marginable position and they would be losing money on the call as the market moved upward. This strategy is commonly called “fence” in cattle price risk management. To be clear, there is nothing wrong this with strategy and I actually teach it in my advanced price risk management programs. But, these producers did not fully understand the strategy they were utilizing. There is nothing wrong with simple strategies and producers may need to start simple and increase the complexity of their risk management strategies as they become more comfortable over time.

Manage the downside first, then worry about the upside
Most risk management strategies involve tradeoffs. Forward contracts and short futures positions trade most all upside price potential to eliminate downside price risk. The exception to this is basis risk, which still exists with futures positions. Strategies like put options, synthetic puts and LRP insurance require payment of premium, which becomes an additional cost. But, these strategies have the advantage of providing some downside protection, while also allowing for upside potential. For the most part, I do like strategies that allow for upside gains as we have seen some crazy volatility over the last several years. However, I typically tell folks to make sure the downside is adequately covered before worrying about upside potential.

Set pricing targets ahead of time
It is nearly impossible to make risk management decisions in real-time as our minds start to play tricks on us. Take for example a backgrounder that places calves in the fall to feed through winter. Then, during the first month or so after placement, the market runs up considerably and expected profit doubles. He / she may really want to take advantage of the higher price expectation, but the market is moving very quickly. And, human nature has them questioning how much higher the market might go. They don’t want to lock in a price, only to see the market continue its rally. This often leads to inaction and sometimes that pricing opportunity gets away. For this reason, if a producer does not want to implement a pricing strategy at placement, I suggest having predefined targets and automatically moving on them when they become available. This might be a certain forward contract price level or an attractive premium for a specific option or LRP coverage level. By setting these targets ahead of time, much of the real-time human nature hesitancies are removed.

Don’t look back once a decision is made
When I talk about this during in-person extension programs, I jokingly say “reach up and rip the rear-view mirror off the windshield.” The point is that it is impossible to manage risk looking backwards. Risk management is about planning and looking forward. If you do a good job managing price risk, you will occasionally jump on a market too soon and price cattle well below what would have been possible. This is frustrating for anyone as it feels like money was left on the table. But, there will also be times when you prevent a significant loss by jumping on an opportunity that was attractive at the time. Risk management is not about maximizing price, it’s about managing downside risk. I like to say that if you aren’t leaving some money on the table occasionally, you are probably taking on too much risk.