Understanding Futures Prices

So what are futures prices anyway?  Futures prices are not the same as cash prices, but there is an important relationship between the two.  A FUTURES PRICE is the price of a CONTRACT between two people for a specific amount of a standardized grade of a commodity to be exchanged on a set date, sometime in the future.

For example, trading specifications for CME corn futures include …  Trading Unit: 5,000 bushels  Deliverable Grades: No. 2 Yellow at par and substitutions at differentials established by the exchange  Price Quote: Cents and quarter-cents/bushel  Tick Size: 1/4 cent/bushel ($12.50/contract)  Daily Price Limit: 12 cents/bushel ($600/contract) above or below the previous day's settlement price (expandable to 18 cents/bu.) No limit in the spot month (limits are lifted two business days before the spot month begins).  Contract Months: Dec, Mar, May, Jul, Sep  Last Trading Day: Seventh business day preceding the last business day of the delivery month  Last Delivery Day: Last business day of the delivery month  Trading Hours: 9:30 a.m. - 1:15 p.m. Chicago time (CST), Mon-Fri. Trading in expiring contracts closes at noon on the last trading day.

Each futures contract has two sides:  Buyer “Long” the market Agrees to take delivery of the commodity at the agreed upon price during the delivery month  Seller “Short” the market Agrees to make delivery of the commodity at the agreed upon price during the delivery month

Most buyers and sellers do not actually deliver or take delivery.  Instead they will go back to the market and offset their position.

A person who bought “long” can offset by selling “short.”  If the price is up, the long trader earns a profit.  If the price is down, the long position has lost money.

A person who sold “short” can offset by buying “long.”  If the price is up, the short trader loses money.  If the price is gone down, the trader earns a profit.

How futures prices are quoted …  Common units like per bushel or pound  Each contract may call for delivery of a much larger amount. A corn contract calls for 5,000 bushels. To find the value of the contract, you multiply the unit price by the number of units in a contract.

Futures price is a REAL price:  A buyer and a seller have reached a business agreement.  This price is much more meaningful than price projection, a forecast, or even a price posted by an elevator operator, which may be at a level at which no one has yet agreed to sell.  Each futures price represents a transaction at a given point in time between a buyer and a seller.

Prices continue to change.  New agreements at different prices are made throughout the trading day.  Each new price represents the market's most current best estimate of the value of the contract.  Prices are in constant flux as buyers and sellers reach new agreements.

Standardization makes trading easier …  Grades, dates and locations are known.  All buyers and sellers know the terms.  Exchanges monitor trading activity and publish futures prices.

Some trading terms: DURING TRADING DAY:  OPEN -- first price of the day  HIGH -- highest price so far  LOW -- lowest price so far  LAST – price for most recent trade  CHANGE -- the difference between the last price and the settlement price for the previous trading day.

The contract month is when delivery will occur …  Prices are often quoted for several months.  Corn months: Dec., Mar., May, July, Sept. December often has lowest prices (near harvest when supplies are high), July often has highest prices (end of the storage season).  If a month appears twice, one is for current year and one is for next year.

Profit and loss …  Futures trades that are offset in the market depend entirely on the change in price level and commission charges. There are no storage or transportation costs.  THE SHORT TRADER will make money if the market drops. In this case, the short has sold at a higher price and repurchased the commodity at a lower price.  THE LONG TRADER will make money if the market rises. In this case, the long has bought at a lower price and resold at a higher price.

The Futures Market

 A. Provides several facilitating and exchange functions 1. Price determination 2. Risk bearing or risk transfer 3. Marketing information

The Futures Market  B. Futures markets buy & sell contracts not the commodity itself 1. Deals with future delivery 2. Specific grade 3. Specific time and place

The Futures Market  C. Futures markets are clearinghouses, impersonal – get buyers and sellers together  D. Round turn: one purchase and one sale of a futures contract. The vast majority of trades eventually become round turns, very very few contracts lead to the actual delivery of the product.

The Futures Market  E. Hedgers and speculators 1. Hedging: taking the opposite position in the futures market as in the cash or product market. It allows a firm or individual to lock in a price. Hedging is a form of insurance. 2. Speculators: betting that the price will rise (bulls) or fall (bear) in the market.  a)If they think the price will fall they will sell futures (short)  b)If they think the price will rise speculators will buy futures (long)  c)Speculators play an important role because they assume risk that hedgers do not want to bare themselves.

Futures and Options  Daily prices units for corn have a +$.12 and a -$.12 stop point for trading  Trading: Hand to chin with 3 fingers = want to trade 3 contracts Hand to forehead with 3 fingers = want to trade 30 contracts Palms away = sell Palms toward = buy Hands to neck = I’m done trading

Futures and Options  Customer Margin = deposit required for buyers/sellers of futures contracts to guarantee their ability to fulfill the contract bought and sold. Example – sell futures for corn at 5,000 bushels at $2.50/bu. (at a 10% margin) The total margin required = 5000 bu. x $2.50 x 10% (or.10) = $1,250

Things To Consider When Hedging (lock in a price)  A. Cost of production  B. Current futures price  C. Basis: the difference between futures price and cash price 1. Transportation costs 2. Storage costs (in the case of grain)  D. Cost of hedging 1. Foregone interest 2. Brokerage cost  E. The cost of hedging can be considered the cost of price insurance  F. A hedge can be lifted at any time

Things To Consider When Hedging (lock in a price)  G. Example: of a simple hedge:  Desired price for corn = $4.40  December futures price = $4.40 Step 1: Sell futures (short) at $4.40 Step 2: December rolls around – buy Futures = $4.00, Cash = $4.00  Cash market desired price = $4.40 Actual selling price =$4.00 -$0.40 loss/bu  Futures marketsell = $4.40 buy =$4.00 +$0.40 profit/bu  This is an example of a Perfect Hedge

Cost of Placing A HEDGE:  Example: Futures price = $4.40, Interest rate = 5% for 1 year  Margin = 5,000 x 4.40 x.10 = $2,200 Foregone Interest = 2,200 x.05 (5%) x 1 = $110 Commission = $50.00 Cost of hedge = $160  Example: What if the hedge is 3 months?  Foregone Interest = 2,200 x.05 x.25 (1/4 of a year) = $27.50 Commission = $50.00 Cost of hedge = $77.50

Buying and Selling of contracts does not mean you are buying and selling commodities

Using Futures

What is a Futures Contract?  Standardized agreement to buy or sell a commodity at a date in the future  Commodity to be delivered  Quantity  Quality  Delivery Point  Delivery Date

Futures  As the delivery month approaches, futures price tend to fall in line with cash market prices  Anyone may buy or sell futures through brokers  Obligation to take delivery on a purchased contract is removed by sell before delivery (Offsetting)  Visa Versa

Hedging  Buying or selling futures contracts as protection against the risk of loss due to changing prices in cash market  Protection against falling wheat market or rising feed cost  Short Hedge: plan to sell a commodity  Long Hedge: plan to buy a commodity

What is Basis?  Relationship between local cash market and futures market price  Basis = cash $ - futures $  a negative number is under  a positive number is over

Short Hedge  Corn Dec. Forward cash market is $4.30  Dec. Future price is $4.55  Basis is 25 cents under  Sell Dec. Corn Future  In Dec. Corn market price is $4.00, Futures price is $4.25 (25 cents under)  Buy back futures contract at $4.25, sell corn for $4.00

Short Hedge  Sell Future $4.55  Buy Future$4.25  Profit =$0.30  Dec Forward $4.30  Dec Cash$4.00  Loss =$0.30  You get $4.00 on cash market plus $.30 from futures = $4.30

What if prices go up?  Sell Future $4.55  Buy Future$4.90  Loss =$0.35  Dec Forward $4.30  Dec Cash$4.65  Profit =$0.35  You get $4.65 on cash market minus $.35 from futures = $4.30

Hedges  If Basis strengthens: Cash=4.30 Fut=4.55 BasisFuture $Cash $Fut GnNet  Protected when price fell, didn’t see the profit when prices went up

Long Hedge  Same as short hedge for buying inputs  Protection against prices rising  Can’t take advantage of a price decline

Margin  Exchange clearing house requires you make a deposit to guarantee possible losses  If prices change significantly, you may have to deposit more money  Contract obligation is Offset when you buy or sell back  Commission charged by brokers for trading contracts

Short Hedge Example:  Sept. you plant winter wheat and expect a 20,000 bu crop  You feel that prices are headed down  $500 per contract margin deposit and commission won’t cause you a problem  You sell 4 wheat futures contracts  What price can you expect?

Short Hedge Example:  July futures price is $3.60, forward cash price is $3.33 (27 cents under)  based on experience, you expect basis to be about 16 cents under  In July, futures price falls to $3.35, cash price to $3.20 (15 cents under)  you buy back 4 futures contracts at $3.35 (25 cent gain)  sell wheat at $3.20 and get $3.45

Short Hedge Example:  Overall gain is 20,000 bu. X’s.25 cents = $5,000 better than cash price  Pay commission of $80/contract

Long Hedge Example:  You plant to buy 120 head of feeder cattle in March  In Dec. indications are that prices will rise  You buy 2 feeder cattle futures (88,000#) at $66/cwt  Futures price goes up to $68.90 in Mar., and cash price is $67  You sell back futures $68.90  Price you pay is $67 minus $2.90 gain in futures market = $64.10

Long Hedge Example:  You have reduced your cost by $2,552 from the cash price  minus commission of $75 /contract  should have a definite plan  should have a target price