Source: Matthew A. Diersen, Professor, Department of Economics, South Dakota State University
Last week I delivered a risk management presentation for cattle producers interested in livestock insurance. Initially is seemed like an odd time of year to be thinking about falling cattle prices. But after visiting with the audience a little, they were interested in what might happen to prices much later this fall and into the winter. Backgrounding, which did not pencil out in South Dakota last year, has been looking profitable this year. Thus, producers were looking at feed prices, talking about high prices for light calves sold in the area, and thinking about the value of their raised calves and raised feed. I, however, was distracted by something else – the low volatility in the cattle market.
A colleague had recently asked me to confirm a marketing strategy she was exploring after hearing about all the volatility in the market. What volatility had she hear about? Certainly prices in recent weeks have changed because of changing corn prices and other factors. However, most producers in the area have not been selling cattle yet and would not have been affected by that type of volatility. I happen to follow another, specific volatility, the implied volatility from cattle futures and options markets. That volatility is low, very low.
The implied volatility is industry’s best guess at how much a futures price will fluctuate between now and when the contract expires. That volatility does not depend on how much cash prices have moved in the recent past. That volatility is the one that producers are worried about. They want to know what will happen to feeder cattle prices by January or March of 2014. Implied volatility for those months has been under 9% in recent weeks. Typical for feeder cattle in recent years has been a volatility level of 15%. A high level of volatility would exceed 20% and a low level would be under 10%. By that reasoning, the volatility is low. Typical live cattle volatility levels are higher than for feeder cattle and the implied volatility is low there too.
Feeder cattle prices this fall are historically high. In contrast, livestock insurance premiums and options premiums are historically low. At-the-money options for deferred months are trading for less than what out-of-the-money options for nearby months were trading for last year. The implied volatility drives the cost the industry charges to transfer risk. At low volatility levels, simple marketing strategies such as buying put options on feeder cattle look attractive. An at-the-money January feeder cattle option would cost about $3.50 per cwt. today with implied volatility at 9%. The same option would cost about $5.75 per cwt. were implied volatility at 15%.