Commodities Future Trading, Commodities Futures, Commodities Markets, Commodities Future Trading - Risks   Commodities Future Trading, Commodities Futures, Commodities Markets, Commodities Future Trading - Risks 
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The trading process

Home > Commodities & Futures > The trading process

Commodities Future Trading, Commodities Futures, Commodities Markets, Commodities Future Trading - Risks
The futures exchange: A mechanism for hedging
Commodity Future Trading can be understood with a simple example. Imagine that you are the proud owner of a large break­fast cereal company. You use a lot of wheat. You know how much it will cost you to advertise your breakfast cereal, how much to pay your employees, how much to heat and light your plant. You even know, roughly, how much you can sell your breakfast cereal for because, to a large degree, your competitors determine the wholesale price for you. However, what you don't know is how much the wheat to make the breakfast cereal will cost you when you need it. Obviously, your greatest concern is that this huge variable cost will rise.

The wheat farmer is worried that the price of wheat will fall by the time it must be sold. The cereal manufacturer is worried that the price of wheat will rise in the future when it must be bought. The futures exchange offers both of them the op­portunity to pre-buy and pre-sell today what they will actually need to physically buy and sell in the future.

If the farmer plants in March, harvests in September and sees that the price of September wheat in March is such that a satisfactory profit could be realized on the crop, he can choose to sell September wheat futures in March. Come September he can deliver the harvested wheat to an elevator approved by the exchange. The cereal manufacturer who knows in January that wheat is needed in July and recognizes that the price of July wheat is cheap enough to purchase now will do so, in order to make breakfast cereal at a nice profit.

In this rather simplified example the farmer and the cereal manufacturer, respectively, contracted to make and take delivery of specified quantities of wheat at specified prices, thereby protecting themselves against any adverse price changes between the time they make their commitments to make and take delivery and the time they would actually physically do so. No matter what happens in the in future, the prices they will receive and pay for their wheat are fixed. In futures parlance, the farmer and the cereal manufacturer, because they seek price assurances, are called hedgers.

A way to provide market liquidity
If all producers and consumers could agree on a fixed price for future delivery, then obviously there wouldn’t be any need for a futures market. But they can't. Producers cannot be absolutely certain they will be able to deliver exactly the quantity they contracted to deliver. The weather could serve to reduce the farmer's yield on his wheat crop.

Nor can the consumer be definite in this commitment to take delivery of exactly what has been contracted for. Business conditions may dictate that the cereal manufacturer buy more or less wheat than contracted for originally. A liquid market is required to allow the farmer and the cereal manufacturer, the producer and consumer to fine-tune their buying and selling. That liquid market comprises the producer, the consumer and the speculator. In the sections that follow you will learn how these elements interrelate in the futures market.

The clearinghouse
The marketplace is anonymous; when you buy or sell you do not know who you're dealing with. Someone has to guarantee that all financial commitments are dealt with in a proper fiduciary manner. The futures exchanges guarantee that all fiduciary commitments are honored through a clearinghouse mechanism. The clearinghouse stands between all buyers and sellers. It is assumed to have taken the opposite side of all transactions made on the exchange. This procedure is supervised by various government regulatory bodies to further ensure against default. It is noteworthy that there has never been a default by an exchange in the history of North American futures trading. That includes the period of the Depression when commercial banks fell like dominoes and the famous dust bowl decimated the North American grain crops.

In addition to guaranteeing fiduciary responsibility, exchange officials also oversee the operations of the markets to ensure they remain fair and orderly. For example, they maintain committees of compliance and complaints. They determine minimum margin requirements and reporting levels, that is, the maximum number of contracts a single individual or corporation is allowed to hold before informing the exchange. This is done to defend against market manipulation by an individual or group.

Exchanges also set daily limits. The limit is the maximum amount a futures price is permitted to move in the course of a single day compared with the previous day's settlement price. It is imposed specifically to protect the small speculator against the weight of much larger traders who could conceivably distort prices over a short time period and thus induce distress liquidation. Generally, limits protect the market against itself. They give all traders another 24 hours to assess the validity and significance of rumors or news.

When a market is up the limit, the contract can still be traded, but only at the limit price or lower. In effect, however, trading usually stops since market factors indicate that the price should be higher than the limit allows. Thus, there are usually no sellers, and potential buyers remain unsatisfied. The converse is true when a market is down the limit. The limits are not arbitrarily imposed; some markets allow for no limits in nearest (or spot) contract months. Also, daily limits may be expanded and contracted according to the judgment of the exchange officials, who at all times seek the most expedient means of matching buyers and sellers.

The players (or traders)
In our introductory comments we mentioned hedgers, who are either producers or users of the actual or cash commodity and who use the futures market as a mechanism to ensure against price variability. For those tempted to think of the futures markets as business-district casinos — and at times it is easy to be tempted — we remind you that the futures markets originated as hedging mechanisms. There has not yet been a market created — there are now some 70 markets that trade everything from Live Cattle to Soybeans to 30-year government-backed Treasury bonds — that did not arise out of the need of potential hedgers to ensure themselves against risk.

As we stated earlier, futures trading is a game. The players, or traders, are quite unlike those in a game like football with its two opposing teams. In futures trading, everyone is on their own. Thousands of players are struggling with each other to come out ahead. The game is played in the "pit", an arrangement of concentric rings of stairs on the floor of each exchange.

Each commodity has its own pit where the players get together and make their moves through floor traders — shouting, frantic individuals who make a business of executing orders for a fee. The players include major grain dealers, who may be securing wheat for an export sale; farmers, selling to protect the value of a new crop or a past crop still in the bins; or the many other producers and users of various commodities. And, of course, we include the speculators. What everyone is trying to do is to buy "low" and sell "high".

The role of the speculator
As we pointed out earlier, the producer and the consumer choose to use the futures market to hedge, that is, to seek price assurance. The speculator's role is to accept the risk of price change in anticipation of future profit. The hedged farmer doesn't know what the price of wheat will be by the time the crop is harvested. Nor does the hedged cereal manufacturer know what prices will be when the time comes for purchasing. It's not their business, not their game.

It is, however, the speculator’s business to forecast what the price of wheat will be in the future. The speculator's game is the method by which he or she decides to buy or sell wheat or any of the other futures contracts traded in Chicago, Kansas City, Minneapolis, Winnipeg, New York, London and elsewhere.

The term game is not randomly chosen. To deal in a fast-moving, freely-traded market, requires many of the skills of gamesmanship. A reasonable definition, then, of a speculator would be someone midway between a gambler and an investor.

The speculator makes assumptions and acts upon them, always recognizing that the apparent arbitrariness and enormous sophistication of the markets can render even the (seemingly) soundest assumptions false.


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