FUTURES AND COMMODITY PRODUCTS
A future product is one that trades on an exchange, where participants with different agendas meet to set a price today for the delivery of a product that will occur at a later time. Among the participants are those that are actively involved with the underlying product and want to “lock in” prices and those who are trading in and out of positions for profits. Among the products offered for trading are contracts on agricultural products, precious metals, base metals, foreign exchange, interest rates, debt products, lumber, petroleum, and indexes. A seller of a future product knows today the price that will be received when his or her product is delivered at a specific date in the future. The buyer of the future knows what will have to be paid upon receipt of the product at that time. For example:
Ms. Lena Board contracts with Ms. June Budds for 1,000 widgets that Lena will make and deliver at the end of six months. June is to pay $1.00 per widget upon receipt. Lena and June have entered into a future contract.
The future product is multifaceted. It is one of the most misunderstood products by the public, as well as by some professionals, and yet it affects our lives more directly than the vast majority of other products that we trade. The product, and its underlying products, is in the news on a daily basis. What is interesting is that when clients have a position on the profitable side of a transaction and they are part of the profit, you will hear that the product is “overregulated.” Conversely, when their position is on the losing side of the market, they might say, “Well, the government ought to do something about this manipulated, out-of-control product.”
As stated above, the future product sets a price today at which a delivery will occur at a later date. The price is based on a projection from today’s market price and on current wisdom about the product and its near- or long-term environment. Often the deliverable underlying product doesn’t even exist at the time the parties enter into the agreement, especially in agriculture products. It is also possible that during the future product’s existence there can be more open contracts outstanding on a particular product than can possibly come to market within the delivery period, and yet no one seems to be overly concerned.
For example, there can be more wheat contracts outstanding in a given month than it is possible to grow, store, or deliver. In addition, some of the products being traded will not actually be received or delivered. Still in other products, it is impossible to deliver the actual product that is underlying the future contract. An interesting feature of some of these products that make up the futures market is that their value increases as their underlying faces adversity. An event happening that affects one product could have an effect on another, completely disassociated product.
Finally, some of the largest positioned traders, who have millions of dollars on the line, may never have actually seen, touched, or eaten the product they are trading—or if they did, they didn’t know it. With some products, a new market begins at the time the futures become deliverable with other products. The deliverable product blends into an existing market and is indistinguishable from the mass.
How do traders know what a price will be six months from now? Actually, they don’t. They try to estimate the value based on the current (spot) market price, augmented by relevant and applicable data such as interest rate costs for carrying the position, storage charges for maintaining it, spoilage (using average past experiences), transportation charges, current economic conditions (globally and locally), trends affecting consumers’ choices, industrial and agricultural trends, governmental programs, economic and weather forecasts—and that’s just to name a few. Many future products are truly global and their value is affected by currency exchange rate changes, foreign government stability, and economic conditions in the far reaches of the earth.
How is future pricing applicable?
Let’s take farming as an example. The farmer must grow crops to sell in a market to earn income. The crops take months to grow from seed to harvest and then to market. The farmer would have an idea as to what the direct expenses and indirect costs should be, but is not sure what price the market would be willing to pay for the product at the later time. The futures market would provide that future price information today. Traders and speculators are using their best assessments to set a price for that month’s future contract. At a minimum, the current spot (cash) price is known, and from there, the assumed futures price can be extrapolated.
The farmer may have a choice of which products to grow during this season and must analyze each one. Based on this factual and projected information, the farmer would then decide which products to grow. If the farmer wanted, he or she could sell contracts on the product selected to plant today, and lock in the selling price that would be received when the product is delivered. Knowing the selling price is locked in, the farmer would then be concerned with the expense side of the equation. If the farmer held the future position until delivery, the price contracted for would be the price the farmer would receive. If the product is selling for more than the contracted amount, the farmer missed out on additional revenue. If the market price is below the contracted price, the farmer is better off financially. The farmer has hedged the value of the actual crop.
As the future contract trades on an exchange, there is a liquid market that affords the farmer the ability to trade in and out of positions, or simply to monitor and adjust the positions during the product’s growing and delivery process. There are other factors affecting the farmer’s decision besides price, though, such as the amount that will actually be grown. Is the farmer concerned about a bumper crop or a thin one? Aside from the amount actually grown, what is the crop’s quality? Many of the products that futures trade on are graded, such as coffee and soybeans. The final price that the farmer would receive is based on the grade the product received. What is actually being traded during the “futures” phase of the cycle is a generic product whose price will be adjusted to reflect its grade. Knowing all of this, the question remains: what percentage of the expected crop does the farmer want to hedge with the futures contracts and how much remains not hedged?
If the farmer doesn’t hedge the crop at all, he or she could face financial ruin if the market price at delivery is far below the growing cost. If the entire expected crop is hedged, the farmer has traded away the possibility of greater profit for protection from earning less. If the total crop grown is less than the amount required by the future contract sold, the farmer must cover the shortage, which may mean acquiring the shortfall in the open market or buying in the short contracts or paying cash for the shortage. Regardless, this action would probably be at a loss.
Each provider or user in the future market faces similar choices and possible results. The above example illustrates the concerns of a farmer, but if assessing the near-term unknown is a problem, what is the impact of all the other viewpoints on the segments of the market? Some participants look at the future long-term, others for less time, still others for seconds or less. All these opinions collectively are what make up the futures market, and through that, price discovery.
Besides the product providers and product users, there are speculators. These people trade for their own accounts and at their own risk. They usually maintain positions for short periods of time, sometimes less than an hour, hoping to profit from their trading prowess. They do not take delivery of the product they are trading the future on, with the exception being when the underlying product is part of the trading strategy. The trading activity they generate adds liquidity to the marketplace. This is reflected not only in tighter spreads (the difference between bids and offers) but also in the depth of the market, which allows it to absorb trades of larger quantities.
Some authors lump the product provider and the product user into one name: “hedgers.” In the above example, the farmer is hedging the value of the crop against unknown risk. The user is doing the same thing by locking in the price of the product against the unknown. The speculators are trading in and out of positions based on the futures’ price trend or anticipation of some data being released. In some markets speculators are known as “scalpers,” because they buy and sell or sell and buy on minimum price movements for short-term gains.
For a future product to exist there must be market risk. The risk can be either real or perceived, or degrees of both. The risk takes the form of market value volatility. Volatility can be caused by the product underlying the future, or its relationship to another product. It can also be caused by pressure from competitive products or some indirect event happening. An example of volatility caused by the product itself is the fluctuation of oil contracts. An oil contract’s price is affected by production, demand, weather, the global economy, the economy of emerging countries, and, most recently, speculators.
For an example of a product that is affected by relationships, look at soybeans. Besides the soybean futures themselves, soybean oil and soybean meal futures are also traded. A fourth product, soybean crush, is also part of the group. About sixty tons of soybeans will produce forty-seven tons of soybean meal and eleven tons of soybean oil. The rest is soybean crush or mash. This is an example of products that have a direct effect on other products. All four products are used for different purposes. Therefore, a change in demand for one affects the other three.
If the growth in the popularity of edamame (soybeans cooked in their pods) continues, the demand will eventually affect the soybean market itself. Theoretically, this would cause fewer soybeans to be processed, which in turn would cause less soybean oil, meal, and crush to be processed, and so on and so forth. What would happen to the prices of the individual soybean products if some respected periodical printed an article stating that tests are under way which are intended to prove that a teaspoon of soybean oil each morning could possibly deter and/or assist in the cure of some dread disease? Do you think the current balance between the soybean products would be affected?
First, the volatility of the soybeans group would increase because of the unknown change in demand on soybeans and soybean oil. It is anyone’s guess how much this news would impact the current supply of soybeans and soybean oil. What would be the degree of shift away from soybeans to soybean oil? Would the impact on soybean meal be positive or negative? If soybean processors start crushing more soybeans to make more soybean oil, what happens to the additional soybean meal that is being produced as a result?
Wheat, rice, corn, and potatoes compete with one another both in the futures market as well as in the spot or cash market. If the price of wheat were to increase to the point where the price of bread and other wheat products became prohibitive, the public would turn to bread made of rice, corn, or potatoes. Producers would gear up to meet the new demand, and the demand for wheat bread would become stagnant, or it would even fall as the demand for the other products increased. We may be witnessing this at present. The increase in the number of people with allergies to wheat and wheat products is growing and at some point may be causing a switch in the demand for wheat. An example of this is the demand for gluten-free products, which use rice, corn, or potatoes as a substitute for wheat.
As summers get hotter, prices on many of the products we eat and/or feed to animals have been increasing already. Some believe the recent summer heat may be an effect of global warming and be permanent. Others believe it is part of a normal cycle. Given the reality of the situation, would you buy or sell long-term agricultural products futures?
As mentioned previously, there must be a strong need, shared by many, to hedge or offload risk. The more diverse the need, the more diverse the interest in the future product will be, the stronger the market in that new product will be. This need will drive the idea for a new product, its purpose, proposed nomenclature, specifications, etc. In other words, those proposing the product must make their case before the Commodity Futures Trading Commission (CFTC) and the case must be strong enough that it will receive approval. The CFTC is an independent federal regulator of the futures market, whose mission is to “protect market users and the public from fraud, manipulations, abusive practices and systemic risk related to derivatives that are subject to the Commodity Exchange Act, and to foster open competitive and financially sound markets.” Besides product approval, the CFTC oversees the futures exchanges, commodity pool operators, commodity trading advisors, commodity futures merchants, and approved persons operating in the industry.
As future products trade on exchanges (either in physical locations, electronic, or both), an exchange that is interested in listing and trading the product will put the proposal forward to the Commodity Futures Trading Commission (CFTC). However, we are getting ahead of ourselves. For a product to be considered, there must be a multiuser need and sufficient interest to support the trading of the product. The size or quantity of the contract must be married to the volatility in such a way that the contract size is large enough to serve the need of many users, and be volatile enough to attract traders and speculators who add liquidity to the market. The volatility, which translates into dollars and cents, must be high enough to be attractive to traders, but not so high that it becomes too expensive for the traders to trade. The relationship between contract size and volatility is a balancing act.
Here’s an example:
The coffee contract is for 37,500 lbs. The minimum trading “tick,” the minimum allowable price movement, is $0.05 or $18.75 per contract (37,500 lbs × $0.05 = $18.75). The wheat contract is for 5,000 bushels of #2 soft red winter, #1 soft red winter at a $0.03 premium, other grades according the exchange rules, minimum tick $0.0025 or $12.50 per contract (5,000 bu. × $0.0025 = $12.50). The S&P 500 index, when originally launched by the Chicago Mercantile Exchange (CME), was set at $500 a point. It grew to become too expensive to trade, though, and was subsequently split 2 for 1 or $250 a point. In 1997, the CME launched the E-mini contract, which is valued at $50 times the index value and has been very successful.
Futures on agricultural products usually have delivery months that coincide with the delivery of the physical product. The delivery destinations are also the same as those of the physical product. Currency futures, which trade in pairs, are settled through financial institutions, such as banks, and their delivery is calendar controlled and set by the marketplace on which they trade. The currency pairs are the “commodity” currency and the “payment” currencies (i.e., EUR/USD, the euro denominated in U.S. dollars).
Not all products that are launched become successful. Years ago a Government National Mortgage Association (GNMA, or Ginnie Mae) future product was launched on the GNMA mortgage-backed pass-through securities. The GNMA product comprises unique pools of government-guaranteed or -insured mortgages. The pools operate as “pass-through” instruments; that is, something that pays interest and pays down mortgage principal monthly. Unlike a corporate bond which pays interest periodically, according to a preset schedule, and pays its principal (the face or amount of the loan) at the end of the loan’s life, the GNMA, as do some other mortgage- and asset-backed securities, periodically pays down the loan or mortgage principal to the loan owner as the borrower pays the loan back to the lender. The underlying principal of the loan is depleting over time. Therefore, each periodic interest payment is based on the principal remaining at that time of the payment. The practitioners of the GNMA future product found the delivery process of the GNMA’s pass-throughs due for settlement cumbersome and awkward, as they had to mix and match mortgage pools. Reacting to the same stimulus in a very similar way was another product that was much easier to work with—the future on U.S. Treasury instruments. The delivery of U.S. Treasury bonds against the Treasury bond future was far simpler, and both products—the GNMA future and the Treasury bond future—traded in similar patterns and served the same hedging purpose. Ultimately, the GNMA future disappeared and is no longer being traded.
It is common lingo to say that futures expire. They do not! If the future position is not closed out when its contracted delivery time has arrived, it transforms from being a future to becoming its underlying product or a cash representation of the same.
The futures contract consists of the components of the following examples:
1. The underlying product and quantity
a. Gold—100 troy ounces
b. Soybeans—5,000 bushels of #2 yellow grown in Indiana, Ohio, Michigan, Iowa, Illinois, and Wisconsin
c. Wheat—5,000 bushels of #2 Soft Red Winter
d. Light crude oil—1,000 barrels
e. Euro—125,000 euros U.S. dollar denominated
2. Trading symbol
a. C—Corn (open outcry)
b. ZC—Corn (CME Globex [Electronic])
c. GC—Gold
3. Pricing unit
a. Cents per bushel
b. U.S. dollars per ounce
4. Tick size (minimum price movement)
a. ¼ of a cent per bushel
b. $0.10 per ounce
a. Dependent on the product (agriculture coincides with the product’s delivery cycle)
6. Method of trading
a. Electronic via computer-based trading programs
b. Open outcry on an exchange floor
7. Trading hours
a. Different times per product group as it is product dependent
8. Daily price limit
a. Some products permit unlimited price swings
b. Allowable price move during a one-day period
c. Trading ceases when exceeded
9. Settlement procedure for:
a. Domestic currency settlers
b. Foreign exchange settlers
c. Product (physical) settlers
d. Produced, adjusted for quality, settlers
10. Last trade date
a. Last opportunity to unwind position
11. Last delivery date
a. Dependent on product
b. Dependent on convention
Here’s an example of a soybean futures contract from the CME Group:
SOYBEAN FUTURES
CONTRACT SIZE
5,000 bushels (136 metric tons)
DELIVERABLE GRADE
#2 Yellow @ contract price
#1 Yellow @ a $0.06/bushel premium
#3 Yellow @ a $0.06/bushel discount
PRICING UNIT
Cents per bushel
TICK SIZE
¼> of a cent per bushel ($12.50 per contract)
CONTRACT MONTHS/SYMBOLS
January (F), March (H), May (K), July (N), August (Q), September (U), and November (X)
TRADING HOURS
CME Globex 5:00 p.m.–2:00 p.m. CT, Sunday–Friday; Open Outcry (floor) 9:30 a.m.–2:00 p.m. CT, Monday–Friday; (opens @ 7:20 a.m.) CT for major USDA crop reports
DAILY PRICE LIMIT
$0.70 per bushel expandable to $1.05 and to $1.60 when the market closes at limit bid or limit offer. There shall be no price limits on the current month contract on or after the second business day preceding the first day of the delivery month.
Daily Grains Settlement Procedure
LAST TRADE DATE
The business day prior to the 15th calendar day of the contract month
LAST DELIVERY DATE
Second business day following the last trading day of the delivery month
TICKER SYMBOL
CME Globex
ZS
S = Clearing
Open outcry S
EXCHANGE RULE
These contracts are listed with and subject to the rules and regulations of the Chicago Board of Trade (CBOT).
Notice: There are the grades acceptable for delivery, and there are daily trading price limits. The limits, which widen each day, are to allow the futures commission merchants (FCMs) to contact their clients and call for more collateral.
The following is a list of the products on which futures contracts are traded:
1. Foreign Exchange
a. Australian dollar
c. Canadian dollar
d. Eurocurrency
e. Japanese yen
f. Mexican peso
g. New Zealand dollar
h. Swiss franc
i. U.S. dollar
2. Precious metals
a. Gold
b. Palladium
c. Platinum
d. Silver
3. Nonferrous metals
a. Aluminum
b. Copper
c. Lead
d. Nickel
e. Tin
f. Zinc
4. Interest rates
a. Eurodollar
b. Euroyen
c. U.S. Treasury 13-week bills
d. U.S. Treasury 5-year notes
e. U.S. Treasury 10-year notes
f. U.S. Treasury 30-year bonds
5. Indices (A-Domestic)
a. Dow
c. NASDAQ 100
d. Hard Red Spring Index
e. Goldman Sachs Commodity
f. National Corn Index
g. National Soybean Index
h. RJ/CRB
i. Russell
6. Indices (B-Foreign)
a. S&P CNX Nifty Fifty
b. Nikkei
7. Animal
a. Feeder cattle
b. Live cattle
c. Lean hogs
d. Pork bellies
8. Agriculture
a. Apple juice concentrate
b. Cocoa
c. Coffee
d. Cotton
e. Orange juice
f. Sugar
g. Wool
9. Dairy
a. Milk
b. International skimmed milk
c. Powder
d. Nonfat dry milk
e. Dry whey
f. Butter
g. Cheese
a. Barley
b. Canola
c. Corn
d. Distillers dried grain
e. Oats
f. Rough rice
g. Soybeans
h. Soybean oil
i. Soybean meal
j. Sugar
k. Wheat
l. Wheat (Black Sea)
m. Wheat (Red Spring)
11. Fuel
a. Brent crude
b. Carbon
c. Crude oil
d. Electricity
e. Heating oil
f. Emissions
g. European Gasoil
h. Gulf Coast Sour Crude
i. Light Sweet Crude
j. Natural Gas
k. RBOB Gasoline
l. Russian Export Blend Crude
12. Lumber
a. Random length lumber
b. Softwood pulp
a. Numerous ETFs are listed
b. Largest in capitalization being PowerShares DB Commodity Index Tracking Fund
14. SWAPs