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A Hedge Strategy

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Anonymous

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Here is a common hedging strategy that may or may not fit the risks you are assuming through your production practicies. This will focus on cattle on feed that will be marketed from February through April. The strategy is a "Synthetic Futures Position" It is called this because it is actually an options position, yet has both unlimited risks as well as unlimited profit potential. What the strategy does is produce a window in which the cash market and futures markets can trade in. This allows free fluctuation of the cash market to climb without inhibiting it up to a certian level, while locking in a predetermind minimum sale price. Here is a current market example. Example only: The current cash market this week is somewhere around $71.00. The February futures closed on the 21st at $78.20. This is a negative basis of $7.20. The synthetic hedge is to buy a $78.00 February put option and sell a $80.00 February call option. The premium you pay is the difference between what you pay for the put and sell the call for. Here is the pro's and con's. The pro is that you have a floor at the $78.00 level minus the premium you paid for the spread. With a $78.00 floor, you have locked in almost all of the current basis available at the time. Another pro is that some of the cost of the put option is offset by the sale of the call option. The con is that if the underlying futures trade above $80.00 then you will be susceptable to a margin call equal to a futures contract and will be at risk how ever high the underlying futures goes beyond $80.00. Why not just buy the put? You can. The cost will just be more. Why not just sell the call? You can, but this would subject you to an unlimited amount of risk with a limited amount of profit potential. The synthetic futures positions allows a lower premium of entry, captures a significant portion of the basis, allows the cash market to climb up to $80.00 before profit potential stops on the cash side, yet does expose the participant to potential losses and margin calls if the underlying futures trade above the $80.00 level. Confuesed now? It's really not as hard as you'd think. If you would like additional information on this strategy or hedging in general, please feel free to contact me at anytime or view my web site at <A HREF="http://www.shootinthebull.com" TARGET="_blank">www.shootinthebull.com</A> . The "Shootin the Bull" commentary can also be viewed at cattletoday.com under "market report"

Futures trading is not for everyone. The risk of loss in trading futures can be substantial; therefore, carefully consider whether such trading is suitable for you in light of your financial condition.



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