Stocks & Commodities V. 31:2 (24-27): Butterflying Cattle With Commodity Options by Tom Gentile

Butterflying Cattle With Commodity Options by Tom Gentile

Moo

Butterfly the strategy, not the steak!

My wife and I don’t frequent the local steakhouse as often as I would like. It’s not me, I love a good cut of filet mignon; she’s just not into red meat. In fact, when we do go, she insists that her beef be well done — so much so that the server often asks if she wants her steak “butterflied.” Butterflying a steak is a process where the chef will split the filet, enabling the steak to cook through quicker. Personally, I think butterflying a steak is a disaster, but butterflying a commodity — now that’s something entirely different.

Let’s take our filet mignon in its rarest form — in the form of live cattle — and look at cutting the meat of this risk substantially.

The butterfly strategy

Cattle futures and options are traded on the Chicago Merchantile Exchange (CME). To give you an idea of the contract values, look at some recent trading action in the cattle pits (Figure 1). The February futures contract for live cattle traded at near 130 cents per pound recently. One contract of live cattle is good for 40,000 pounds, according to the specifications. To get the contract price, you simply multiply the current price of the contract by the contract size (130 x 40,000).

The February contract on December 3, 2012, is worth approximately $52,000. With overnight margins, the cost to control the contract is obviously much less, but we need to remember the calculations in order to determine the dollar cost of the options.