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Marketing Sample Lesson
MK110 How Futures Contracts Are Traded
This lesson adds to what you started to learn in AgEdNet.com lesson MK109 Understanding Futures Prices. A concept to keep in mind is that a futures market is a place where contracts are traded. A LEGAL CONTRACT The futures contract is a legal commitment, a promise, to either make delivery or accept delivery of a commodity such as corn, wheat, cotton or live cattle.
The delivery is at a set location for a specific grade of a commodity at a fixed price at a given date. Because they are standard agreements, trades can be made easily and quickly. All traders know exactly what they are buying and selling because the contracts are standardized and each unit of the commodity is the same as any other. The only variable is the price. The price of each contract is determined by public bidding between buyers and sellers. The requirement that all trades are made in public is very important. It assures that the market will remain fair and competitive. There are no behind-the-scenes deals in which better prices may be available to big buyers than to small traders. The concept is to give everyone the same chance to buy or sell. PURPOSE OF TRADING EXCHANGES The exchanges are organized to provide facilities for trading the contracts. They do not set prices or trade in the markets. Prices are arrived at by what the exchanges call open auction or open outcry bidding. The traders offer bid and ask prices. When two of the traders agree on a price, a contract is made. The exchanges make public the prices at which the contracts trade. They also provide clearinghouse facilities. The clearinghouse guarantees the performance of all contracts. These contracts can be fulfilled in two ways: 1. By physical delivery: One way to fulfill the contract is by physical delivery of the actual commodity -- corn, cotton, soybeans, lean hogs, etc. The commodity delivered must be the grade specified by the contract and must be delivered at a location approved by the contract by the date required under the contract. The trader who owns the short side of the contract delivers the commodity and the trader who is long must pay for it and take it away. If a trader holding a long contract has not made arrangements for transportation, there is a standard agreement to store the commodity. The long trader will then receive a warehouse receipt and a bill for storage every month. Physical delivery is not an important objective of the futures market. Futures markets are more concerned with the value of the contract and the commodity that it represents than with physical delivery. About 99 percent of all futures market participants close out their contracts with offsetting positions. The main purpose of delivery is to maintain a strong link between the futures and cash market. The fact that traders are obligated to make delivery, or accept delivery causes futures prices to reflect cash market values. 2. By offsetting positions with another trade: Contracts can also be fulfilled by offsetting positions with another futures trade. Traders who are long or short can fulfill their contract obligation with a contract that is the opposite of their first position. A trader who has sold short will buy long to offset the position; a trader who has bought long will sell short. EXAMPLE: If you are long December corn, you have a contract that requires you to buy December corn. If you do not want to take delivery of that corn, you can go back to the futures market and sell, taking a short position. That requires you to make delivery of December corn. Now you have two promises -- one to take delivery and one to make delivery at the same time, at the same place. The two positions cancel each other. Profit or loss on 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.
ANYONE CAN BUY OR SELL Futures markets become so competitive because anyone with adequate financial resources can buy or sell on futures markets. They need not own the commodity or have facilities to store or transport it. Futures contract markets are as close as your telephone. Futures can be bought or sold from anywhere. People anywhere can trade standard commodities and have the opportunity to make profits in a market without having to deliver or take delivery of the physical commodity. Once you have established an account with a broker, you can open and close positions over the phone. In order to ensure that the people will fulfill their legal obligations, they are required to make a security deposit called a margin. However, this margin represents a small percentage of the total value of a contract. When you take a position in the futures market, you have to give your broker enough money to ensure that you will fulfill your promise. Your margin account is like a bank account. Once you buy or sell futures, your margin account will reflect your profit or loss in the positions you hold.
If you do not deposit more money, the broker has the legal right to close your position. Your losses will be deducted from your margin account. If your margin balance is not large enough to cover your losses, you will still owe the brokerage firm the difference. PROFITS BALANCE LOSSES For every dollar that someone makes in the futures market, someone else has to lose a dollar. The markets are quite real in the sense that lots of money changes hands. The contracts have value even if they are never used to deliver or receive the actual commodity. It is important to remember that contracts are being traded, not the actual commodities. These legal contracts represent the obligation to either make delivery or take delivery of a certain amount of a specific grade of a commodity at a given location on a set date. EXERCISES: Discuss in class and/or write a report answering the following: 1. Now that you have learned some concepts of how both cash and futures operate, start giving some thought to how you, as a commodity producer, might make use of futures contract trading to achieve your pricing objectives. Assume that you want to use the futures market to set a price on 10,000 bushels of corn that you own. Explain the trade terms that: A. Describe your market position when you are holding 10,000 bushels of corn in storage; and B. Describe the futures market position you would need to take in order to sell your 10,000 bushels of corn. 2. The process used to offset a cash market position with a futures position is called hedging. You'll learn much more about that in future lessons. In nearly every case, a hedge will be closed out with an offsetting position in the futures market at the same time that the hedged commodity is sold in the cash market. From what you have learned so far, why it would not be advisable for a producer to deliver the commodity to settle the contract? 3. Contact a local brokerage firm to find out what is required for a producer to open a hedging account. Explain that you are a student in the process of learning more about the markets. You also may want to find out more about what services are provided and what commissions are required to place hedges on futures and options markets. Once you get the information, make a list of what is required to place a hedge. Then explain which of the requirements you feel is most important. INTERNET RESOURCES:
** Chicago Mercantile Exchange (CME)
** Intercontinental Exchange, Inc. (ICE)
** Kansas City Board of Trade
** Minneapolis Grain Exchange home page
** Stewart-Peterson TEST:
1. A grain producer who has rented land; purchased seed, fertilizer and fuel; and planted a crop, but has not yet harvested it could be considered:
2. A grain producer who has harvested a crop, placed it in storage and entered into offsetting futures positions could be considered:
3. A grain producer who has harvested and stored a crop, entered into offsetting futures contracts, but then lifted the futures positions could be considered:
4. If you have a long futures market position you: 5. The two ways a speculator or hedger can fulfill a futures contract are by taking __________ positions and by __________ or __________ delivery.
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TEACHER'S GUIDEMK110 How Futures Contracts Are TradedOBJECTIVE: Students will understand and be able to explain how contracts are actually traded on futures exchanges. They also will begin to learn more of the market "jargon" often used by brokers and found in market reports. PREPARATION: Review lesson content and be ready to answer student questions. NOTE that this lesson could be used as a unit on understanding futures along with AgEdNet.com lessons MK109 Understanding Futures Prices and MK111 Linking Cash and Futures Markets. Review the Web sites listed under Internet Resources. INTERNET RESOURCES:
** Chicago Mercantile Exchange (CME)
** Intercontinental Exchange, Inc. (ICE)
** Kansas City Board of Trade
** Minneapolis Grain Exchange home page
** Stewart-Peterson IMPORTANT TERMS: ask, bid, clearinghouse, delivery hedge, hedger, long, margin, margin account, margin call, offsetting positions, open auction, open outcry, physical delivery, trader. EXTENSION: Have the class pick a futures contract and take a "paper" position in the market. Have the students take turns getting the closing price each day and calculating the value of the account. Assume that your account has a 10 percent margin requirement for purposes of determining margin calls. As an alternative, you may want to arrange a visit to a local brokerage firm. This could be done to gather information for Exercise #3. Be sure to have an appointment for your group. You may wish to do this later in the day when the markets are closed and a broker will have time to answer your questions. EXERCISE ANSWERS: 1. In futures terminology, the farmer holding corn is LONG in the cash market. The farmer faces the same risk of price change as the futures trader who has purchased a contract that calls for delivery. They own, or have agreed to purchase ownership of the commodity. To set a price on stored corn, you would take an offsetting position in the futures market. Thus, if you are already LONG in the cash market you will want to take a SHORT position on the futures market. The SHORT contract calls for delivery of corn in the contract month, while the LONG contract holder has agreed to take delivery. 2. Delivery requires that you meet specific grade requirements. In addition, delivery must be at elevators approved by the exchange. That could well require transportation costs. Delivery must be at a specific time, which may not be possible from your location. Bottom line: The cost of delivering would be far greater than the cost of offsetting and then selling at one of your normal cash market locations. 3. It will be helpful for students to get current information about the different requirements for hedgers and speculators. Most firms will be happy to cooperate by providing samples of forms, commission rates, etc. Students should become aware that the brokers are responsible for making sure that their customers are able to afford the financial risk of trading. TEST KEY:
1. A grain producer who has rented land; purchased seed, fertilizer and fuel; and planted a crop, but has not yet harvested it could be considered: Correct answer: B. Long the market, because the farmer has already made significant investments in producing a crop and is AT RISK of price changes in the value of the crop to be harvested.
2. A grain producer who has harvested a crop, placed it in storage and entered into offsetting futures positions could be considered: Correct answer: D. Hedged, because the long cash position is offset by a short futures position. Financial risk of price change has been shifted from the farmer to the speculators who own the long side of the futures contracts.
3. A grain producer who has harvested and stored a crop, entered into offsetting futures contracts, but then lifted the futures positions could be considered: Correct answer: B. Long the market. While the farmer was hedged, lifting the futures position means the farmer is again at risk of price change on grain being held. A farmer is never really "out of the market" because of investments in equipment and land that will be used for future production. Changes in price put future earnings on those investments at risk.
4. If you have a long futures market position you: Correct answer: C. May have to take delivery, is the best answer, however, a livestock producer who is hedging the purchase of grain may also be long the futures to offset expected cash market purchases.
5. The two ways a speculator or hedger can fulfill a futures contract are by taking offsetting positions and by making or taking delivery.
END
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