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Temperature, precipitation and the changing needs of customers all contribute
to the supply and demand for commodities like wheat, corn or soybeans. All of
these changes greatly affect the price of commodities, and the grain markets
are essential to managing these price swings and providing global benchmark
prices. Read on to dig into and learn about the seven major products of the
grain markets.
SEE: Futures Fundamentals
What Are Grain Futures Contracts?
Anyone looking to invest in futures should know that the risk of loss is
substantial. This type of investment is not suitable for everyone. An investor
could lose more than originally invested and, therefore, only risk capital
should be used. Risk capital is the amount of money that an individual can
afford to invest, which, if lost would not affect the investor's lifestyle.
A grain futures contract is a legally binding agreement for the delivery of
grain in the future at an agreed-upon price. The contracts are standardized by
a futures exchange as to quantity, quality, time and place of delivery. Only
the price is variable.
There are two main market participants in the futures markets: hedgers and
speculators. Hedgers use the futures markets for risk management and withstand
some risks associated with the price or availability of the actual underlying
commodity. Futures transactions and positions have the express purpose of
mitigating those risks. Speculators, on the other hand, generally have no use
for the commodities in which they trade; they willingly accept the risk
involved in investing in futures in return for the prospect of dramatic gains.
Advantages of Futures Contracts
Because they trade at the Chicago Board of Trade (CBOT), futures contracts
offer more financial leverage, flexibility and financial integrity than trading
the commodities themselves.
Financial leverage is the ability to trade and manage a high market value
product with a fraction of the total value. Trading futures contracts is done
with performance margin; therefore, it requires considerably less capital than
the physical market. Leverage provides speculators a higher risk/higher return
investment.
For example, one futures contract for soybeans represents 5,000 bushels of
soybeans. Therefore, the dollar value of this contract is 5,000 times the price
per bushel. If the market is trading at $5.70/bushel, the value of the contract
is $28,500 ($5.70 x 5,000 bushels). Based on current exchange margin rules, the
margin required for one contract of soybeans is only $1,013. So for
approximately $1,013, an investor can leverage $28,500 worth of soybeans.
Advantages of Grain Contracts
Because grain is a tangible commodity, the grain market has a number of unique
qualities. First, when compared to other complexes like the energies, grains
have a lower margin making it easy for speculators to participate. Also, grains
generally aren't one of the bigger contracts (in terms of total dollar amount),
which accounts for the lower margins.
The fundamentals in the grains are fairly straightforward: like most tangible
commodities, supply and demand will determine the price. Weather factors will
also have an effect.
Contract Specifications
There are seven different grain products traded at the Chicago Board of Trade:
corn, oats, wheat, soybeans, rice, soybean meal and soybean oil.
Similar grain products trade in other commodities markets around the world,
such as Minneapolis, Minn; Winnipeg, Manitoba; Hong Kong; Brazil and India to
name a few.
1. Corn
Corn is used not only for human consumption, but to feed livestock such as
cattle and pigs. Also, higher energy prices have made people look at using corn
for ethanol production.
The corn contract is for 5,000 bushels, or roughly 127 metric tons. For
example, when corn is trading at $2.50/bushel, the contract has a value of
$12,500 (5,000 bushels x $2.50 = $12,500). A trader that is long $2.50 and
sells at $2.60 will make a profit of $500 ($2.60 - $2.50 = 10 cents, 10 cents x
5,000 = $500). Conversely, a trader who is long at $2.50 and sells at $2.40
will lose $500. In other words, every penny difference equals a move up or down
of $50.
The pricing unit of corn is in dollars and cents with the minimum tick size of
$0.0025, (one-quarter of a cent), which equals $12.50 per contract. Although
the market may not trade in smaller units, it most certainly can trade in full
cents during "fast" markets.
The most active months for corn delivery are March, May, July, September and
December.
Position limits are set by the exchange to ensure orderly markets. A position
limit is the maximum number of contracts that a single participant can hold.
Hedgers and speculators have different limits. Corn has a maximum daily price
movement of 20 cents, up or down.
Corn traditionally will have more volume than any other grain market. Also, it
will be less volatile than beans and wheat.
2. Oats
Oats are not only used to feed livestock and humans, but are also used in the
production of many industrial products like solvents and plastics.
An oats contract, like corn, wheat and soybeans, is for the delivery of 5,000
bushels. It moves in the same $50/penny increments as corn. For example, if a
trader is long oats at $1.40 and sells at $1.45, he or she would make 5 cents
per bushel, or $250 per contract ($1.45 - $1.40 = 5 cents, 5 cents x 5,000 =
$250). Oats also trades in quarter-cent increments.
Oats for delivery are traded March, May, July, September and December, like
corn. Also like corn, oats futures have position limits. The maximum price
movement of oats is 20 cents.
Oats is a difficult market to trade because it has less daily volume than any
other market in the grain complex. Also its daily range is fairly small.
3. Wheat
Not only is wheat used for animal feed, but also in the production of flour for
breads, pastas and more.
A wheat contract is for delivery of 5,000 bushels of wheat. Wheat is traded in
dollars and cents and has a tick size of a quarter cent ($0.0025), like many of
the other products traded at the CBOT. A one-tick price movement will cause a
change of $12.50 in the contract.
The most active months for delivery of wheat, according to volume and open
interest, are March, May, July, September and December. Position limits also
apply to wheat - the daily price limit is 30 cents.
Next to soybeans, wheat is a fairly volatile market with big daily ranges.
Because it is so widely used, there can be huge daily swings. In fact, it is
not uncommon to have one piece of news move this market limit up or down in a
hurry.
4. Soybeans
Soybeans are the most popular oilseed product with an almost limitless range of
uses, ranging from food to industrial products.
The soybean contract, like wheat, oats and corn, is also traded in the 5,000
bushel contract size. It trades in dollar and cents, like corn and wheat, but
is usually the most volatile of all the contracts. The tick size is one-quarter
of a cent (or $12.50).
The most active months for soybeans are January, March, May, July, August,
September and November.
Position limits apply here as well. The maximum price limit for beans is 50
cents.
Beans have the widest range of any of the markets in the grain room. Also, it
will generally be $2 to $3 more per bushel than wheat or corn.
5. Soybean Oil
Besides being the most widely used edible oil in the United States, soybean oil
has uses in the bio-diesel industry that are becoming increasingly important.
The bean oil contract is for 60,000 pounds, which is different from the rest of
the grain contracts. Bean oil also trades in cents per pound. For example,
let's say that bean oil is trading at 25 cents per pound. That gives a total
value for the contract of $15,000 (0.25 x 60,000 = $15,000). Suppose that you
go long at $0.2500 and sell at $0.2650; this means that you have made $900
($0.2650 - 25 cents = $0.015 profit, $0.015 x 60,000 = $900). If the market had
gone down $0.015 to .2350, you would lose $900.
The minimum price fluctuation for bean oil is $0.0001, or one one-hundredth of
a cent, which equals $6 per contract.
The most active months for delivery are January, March, May, July, August,
September, October and December.
Position limits are enforced for this market as well; 2 cents is the price
limit for bean oil.
6. Soymeal
Soymeal is used in a number of products, including baby food, beer and noodles.
It is the dominant protein in animal feed.
The meal contract is for 100 short tons, or 91 metric tons. Soymeal is traded
in dollars and cents. For example, the dollar value of one contract of soymeal,
when trading at $165 per ton, is $16,500 ($165 x 100 tons = $16,500).
The tick size for soymeal is 10 cents, or $10 per tick. For example, if the
current market price is $165.60 and the market moves to $166, that would equal
a move of $400 per contract ($166 - $165.60 = 40 cents, 40 cents x 100 = $400).
Soymeal is delivered on January, March, May, July, August, September, October
and December.
Soymeal contracts also have position limits; the daily price limit for soymeal
is $2.
7. Rice
Not only is rice used in foods, but also in fuels, fertilizers, packing
material and snacks. More specifically, this contract deals with long-grain
rough rice.
The rice contract is 2,000 hundred weight (cwt). Rice is also traded in dollars
and cents. For example, if rice is trading at $10/cwt, the total dollar value
of the contract would be $20,000 ($10 x 2,000 = $20,000).
The minimum tick size for rice is $0.005 (one half of a cent) per hundred
weight, or $10 per contract. For example, if the market was trading at $10.05/
cwt and it moved to $9.95/cwt, this represents a change of $200 (10.05 - 9.95 =
10 cents, 10 cents x 2,000 cwt = $200).
Rice is delivered in January, March, May, July, September and November.
Position limits apply in rice as well, with a daily price limit of 50 cents.
Centralized Marketplace
The primary function of any commodity futures market is to provide a
centralized marketplace for those who have an interest in buying or selling
physical commodities at some time in the future. There are a lot of hedgers in
the grains markets due to the many different producers and consumers of these
products. These include, but are not limited to, soybean crushers, food
processors, grain and oil seed producers, livestock producers, grain elevators
and merchandisers.
Using Futures and Basis to Hedge
The main premise upon which hedgers rely is that although the movement in cash
prices and futures market prices may not be exactly identical, it can be close
enough that hedgers can lessen their risk by taking an opposite position in the
futures markets. By taking an opposite position, gains in one market can offset
losses in another. This way, hedgers are able to set price levels for cash
market transactions that will take place several months down the line.
For example, let's consider a soybean farmer. While the soybean crop is in the
ground in the spring, the farmer is looking to sell his crop in October after
the harvest. In market lingo, the farmer is long a cash market position. The
fear for the farmer is that prices will go down before he can sell his soybean
crop. In order to offset losses from a possible decline in prices, the farmer
will sell a corresponding number of bushels in the futures market now and will
buy them back later when it is time to sell the crop in the cash market. Any
losses resulting from a decline in the cash market price can be partially
offset by a gain from the short in the futures market. This is known as a short
hedge.
Food processors, grain importers and other buyers of grain products would
initiate a long hedge to protect themselves from rising grain prices. Because
they will be buying the product, they are short a cash market position. In
other words, they would buy futures contracts to protect themselves from rising
cash prices.
Usually there will be a slight difference between the cash prices and the
futures prices. This is due to variables such as freight, handling, storage,
transport and the quality of the product as well as the local supply and demand
factors. This price difference between cash and futures prices is known as
basis. The main consideration for hedgers concerning basis is whether it will
become stronger or weaken. The final outcome of a hedge can depend on basis.
Most hedgers will take historical basis data into consideration as well as
current market expectations.
The Bottom Line
In general, hedging with futures can help the future buyer or seller of a
commodity because it can help protect them from adverse price movements.
Hedging with futures can help to determine an approximate price range months in
advance of the actual physical purchase or sale. This is possible because cash
and futures markets tend to move in tandem, and gains in one market tend to
offset losses in another.
by Hank King
Hank King currently works at Trendphonics at the Chicago Board of Trade as a
senior broker. He has been in the business since 2000 and has worked as a
Nasdaq trader for Great Point Capital, a clerk on the floor of the CBOT with
Fimat and as an account executive with Morgan Stanley and Lind Waldock. King
has his Series 3 license and graduated from the University of Arizona with a
major in art history.