futures: speculation

FUTURES: SPECULATION

• Types of speculators:

– Short term• Scalpers• Day traders

– Long term

FUTURES: SPECULATION• Types of speculators:

– “Spreaders”• Spread

– Price difference between two different markets or commodities

» Spreads across commodities: Steers vs. corn, soybeans vs. soyoil and soymeal

» Spreads across time: Corn December vs. July futures


• “Spreaders” simultaneously buy and selling in two related markets in the expectation of making a profit when positions are offset


• Example of spreading:

– Suppose on April 15th:• KCBT HRW December wheat futures price is $4.07/bu• CBOT SRW December wheat futures price is $4.04/bu

– Suppose a person is bullish about the KCBT-CBOT spread (e.g., he believes spread will rise to $0.10/bu)

– Trading strategy for bullish speculator on the spread:1. Go “long” (i.e., buy) the spread now at $0.03/bu2. “Offset” (i.e., sell back) the spread sometime before December

(hopefully, for more than $0.03/bu)

Spread KCBT-CBOT = $4.07/bu – $4.04/bu

= $0.03/bu

FUTURES:SPREADING EXAMPLE

• Correct forecast scenario, prices rise

KCBT CBOT Spread

Apr. 15 Buy @4.07/bu [email protected]/bu $0.03/bu



KCBT CBOT Spread


Sep. 20 Sell back Buy back @4.57/bu @4.47/bu $0.10/bu



KCBT CBOT Spread



Gain (Loss) $0.50/bu (–$0.43/bu)

NET GAIN $0.07/bu (minus broker commissions)


• Correct forecast scenario, prices fall

KCBT CBOT Spread




KCBT CBOT Spread





KCBT CBOT Spread



Gain (Loss) (–$0.50/bu) $0.57/bu

NET GAIN $0.07/bu (minus broker commissions)

Basis

• BASIS = Cash - Futures– Local Spot Price – Futures Price

• Cash = Basis + Futures– Provides a forecast of cash prices

– Basis is more predictable than futures

BASIS: GENERALITIES

• Basis reflects factors that affect local cash price relative to futures price at delivery point– Local supply and demand factors

• Yield• Quality• Storage availability• Processing capacity• Rail car availability• Consumption

FUTURES: DEFINITIONS

BASIS: GENERALITIES

• Spot and futures tend to move together.

• Futures price converges to spot price (at delivery location) as maturity gets closer

• Hence:– Basis converges to zero (at delivery

location) as maturity gets closer

BASIS: GENERALITIES

1.20

0

Time

Sp

ot

an

d F

utu

res

pri

ce

s FarFutures

Spot

NearbyFutures

Nearby Expiration Far Expiration

ISM Lean Hog Basis

$(20)

$(10)

$-

$10

$20

$30

$40

$50

$60

$70

$80

$90

2/27

/95

2/27

/96

2/27

/97

2/27

/98

2/27

/99

2/27

/00

2/27

/01

2/27

/02

2/27

/03

2/27

/04

$/cw

t Car

cass

Spot Basis

Spot BasisAverage 58.63 -1.97Std Dev 13.71 3.99Min 15.36 -15.12Max 88.47 12.33

BASIS: GENERALITIES

• For storable commodities at delivery location:

Current Futures Price Current Spot price+ Storage Cost

• Hence:– Basis - Storage Cost

BASIS: GENERALITIES

• Basis generally follows seasonal patterns– Grains typically widest at harvest then

narrow until the next harvest– Livestock varies, but follows the tendencies

• Seasonal spot price• Converging at expiration

Iowa Live Cattle Basis, 2002-2005 ($/cwt)

$(4)

$(3)

$(2)

$(1)

$-

$1

$2

$3

$4

$5

Jan

1-15

Feb 1

-15

Mar

1-1

5

Apr 1

-15

May

1-1

5

Jun

1-15

Jul 1

-15

Aug 1

-15

Sep 1

-15

Oct 1-

15

Nov 1

-15

Dec 1

-15

FUTURES: DEFINITIONS

• There is a BASIS for each futures contract and for each location

• If futures contract not specified, basis implicitly calculated using “nearby” contract month

Hedging definition• Holding equal and opposite positions in

the cash and futures markets

• The substitution of a futures contract for a later cash-market transaction

HEDGING

• Manage risk– Risk: A chance of an unfavorable

outcome

• Risk Management– Management is not avoidance

• No risk, no reward• Too much risk and you may not be in

business to receive the reward

Why Hedge?

• Two major types of risks– Production risk

• Yield, efficiency, death loss, fire, spoilage

– Price risk

• For most commodity producers and handlers, price risk is greater than production risk

HEDGING

• Risk Management

– Production• Management practices• Crop insurance

– Price• Alternative contractual arrangements• Hedging with futures

– Buying or selling futures contracts to protect from losses due to adverse movements in spot prices

FUTURES: HEDGING

• Hedgers:

– Either “produce” or “consume” the commodity

– Face “spot price risk”• Risk of losses from unfavorable spot price

movements

– Buy or sell futures in an attempt to reduce their spot price risk

Short Hedgers

• Producers with a commodity to sell at some point in the future– Are hurt by a price decline

• Short hedgers1 Sell the futures contract initially2 Buy the futures contract (offset) when they

sell the physical commodity

SHORT HEDGE:WHY DOES IT WORK?

Position Diagram:Net Profits for Long Spot Position

-3

-2

-1

0

1

2

3

4

0 1 2 3 4 5 6

Spot Price at Time of Selling Commodity

Ne

t P

rofi

ts p

er

Un

it o

f C

om

mo

dit

yProduction

Cost

Position Diagram:Net Profits for Short Position in Futures

-4

-3

-2

-1

0

1

2

3

4

0 1 2 3 4 5 6

Futures Price at Time of Offsetting

Ne

t P

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ts p

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Un

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y

Futures Priceat which Short

Position is Open

Long Hedgers

• Processors or feeders that plan to buy a commodity in the future– Are hurt by a price increase

• Long hedgers1 Buy the futures initially2 Sell the futures contract (offset) when they

buy the physical commodity

LONG HEDGE:WHY DOES IT WORK?

Position Diagram:Net Profits for Long Position in Futures

-4

-3

-2

-1

0

1

2

3

4

0 1 2 3 4 5 6

Futures Price at Time of Offsetting

Ne

t P

rofi

ts p

er

Un

it o

f C

om

mo

dit

y

Futures Priceat which Long

Position is Open

Position Diagram:Net Profits for Short Spot Position

-3

-2

-1

0

1

2

3

4

0 1 2 3 4 5 6

Spot Price at Time of Buying Commodity

Ne

t P

rofi

ts p

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Un

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Revenue

FUTURES: HEDGING

• Short (Selling) Hedge

– Protects from FALL in spot price

– “Locks in” a SELLING price

• Long (Buying) Hedge

– Protects from RISE in spot price

– “Locks in” a PURCHASING price

Preharvest short hedge example

• A farmer will have 50,000 bushels of corn to sell after harvest– The farmer is long the cash market

• Damaged by a price decline


• To have an equal and opposite hedge the farmer would sell 10 corn futures contracts that expires near the expected marketing time.– The farmer would short the futures

• The futures position would benefit from a price decline

Preharvest short hedge exampleStep 1: Know cost of production

Step 2: Convert futures price to local price using the basis

For this farmer the historic basis for December corn is $0.25 under the board.

Currently Dec corn trading at $2.50

Local basis -.25

Commission -.01

Expected hedge price $2.24

Preharvest short hedge example• Step 3: Call broker and place order to sell

10 Dec Corn contracts at the market

• Step 4: Broker calls to confirm fill

• Step 5: Send margin money to broker


• It is now November and the farmer harvests 50,000 bu of corn and delivers it to the local elevator.

• Prices could have gone up or down

• Basis could be wider or narrower than expected

Hedging example Higher PricesDec Corn futures = $3.00Basis as expected -$0.25Cash corn $2.75Futures position loss

$2.50 - 3.00 -0.01 -$0.51

Net price $2.24

Hedging example Lower PricesDec Corn futures = $2.20Basis as expected -$0.25Cash corn $1.95Futures position gain

$2.50 - 2.20 -0.01 +$0.29

Net price $2.24

Hedging example Basis ChangeDec Corn futures = $2.20

Basis is wider -$0.30

Cash corn $1.90

Futures position gain

$2.50 - 2.20 -0.01 +$0.29

Net price $2.19

Expected $2.24 and received $2.19

Difference is due to basis change

Hedging results

• In a hedge the net price will differ from expected price only by the amount that the actual basis differs from the expected basis.

• Basis estimation is critical to successful hedging

Long Hedge Example

• An ethanol plant needs corn year around and wants to protect itself from higher corn prices in July.

• It is short the cash market.– Will be hurt by a corn price increase

• Will take a long futures position, buy July corn– Will benefit from higher July corn prices

Long Hedge Example

Currently July corn trading at $2.70

Local basis -.25

Commission +.01

Expected hedge price $2.46

Call Broker and buy July corn at $2.70

Long Hedge Example

It is now July and prices went up. Call broker and sell July corn to offset:


Local basis -.25

Cash price $2.65

Futures position gain

$2.90 - 2.70 -0.01 +$0.19

Net price $2.46

Long Hedge Example

It is now July and prices went down. Call broker and sell July corn to offset:


Local basis -.25

Cash price $2.05

Futures position loss

$2.30 - 2.70 -0.01 -$0.41

Net price $2.46

SHORT HEDGEExample 1: MIDDLEMEN

• “Storage” Hedge:

– It is March. You own a grain elevator and must decide whether to buy and store soybeans until July

• Current soybeans spot price = $5.75/bu

• Storage cost = $0.13/bu


• Soybean Contract Months:• March• May• July• August• September• November• January

• Current August futures = $6.30/bu

• Expected July basis = $0.25/bu UNDER August

Expected Local Spot Price Next July

= $6.30/bu + (–$0.25/bu)

= $6.05/bu


• Storage is expected to be profitable

BUT

Risky because price of soybeans may fall

• Decision: Storage and short hedge

Expected profits from storage

= $6.05/bu – $5.75/bu – $0.13/bu

= $0.17/bu

SHORT HEDGE Example 1: MIDDLEMEN

SPOT FUTURES BASIS ACTIVITY ACTIVITY

MAR Buy @ $5.75 Sell Aug. @ $6.30 Expected -$0.25


• Scenario 1: Prices FALL



JUL Sell @ $4.25 Buy back @ $4.50 Actual -$0.25


• Scenario 1: Prices FALL




Spot Price + Futures Gain (Loss) = Net Selling Price

$4.25 + $1.80 = $6.05

as expected


• Scenario 2: Prices RISE





• Scenario 2: Prices RISE




Spot Price + Futures Gain (Loss) = Net Selling Price

$7.50 + (-$1.45) = $6.05

as expected

The Storage Hedge

• Gain from a narrowing basis• Futures increased less than cash• Watch for historically wide basis to begin

storage hedge in hope that the basis will narrow

• The futures position protects against falling prices during storage period

NOTE ON HEDGING!!!

• Short Hedge:– Net SELLING Price =

Spot Price + Futures Gain (Loss)

• Long Hedge:– Net BUYING Price =

Spot Price - Futures Gain (Loss)

futures: speculation

Documents

kcbt cbot spreadapr

wheat futures price

kcbt hrw

forecast of cash pricesbasis

local cash price relative

delivery location

bunet gain

bugain loss