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2. Commodity Futures Trading Terms

Every specialized activity has its own unique vocabulary which needs to be learned so the free flow of information can occur. The commodity futures environment contains numerous commodity futures trading terms which you need to become familiar with so you can precisely communicate your wishes to your broker.

This chapter contains an overview of how the futures markets work and who the participants are. It also describes basic futures terms which are used in this course. The Commodity Trading Glossary (Appendix A) contains virtually every term used in the commodity futures trading environment.

When you buy or sell a futures contract, you don't actually buy or sell the commodity. You are controlling a futures contract, which is commercial paper (i.e., a negotiable instrument). Every futures contract specifies performance criteria (whether you will make delivery, take delivery, the performance due date, the commodity quantity, etc.).

Very few speculators (that's you) actually intend to make or take delivery, and instead transfer their contractual obligation to someone else in the marketplace. This is called offsetting your position, after which you are no longer obligated to the contract's performance criteria. However, any profit or loss which has accrued during the time which you were the holder of the contract - that is, from your entry price to your exit price is posted to your trading account.

Margin Requirement

Each Futures Exchange requires its market participants to deposit and maintain in their accounts a certain minimum amount of funds for each open position held. These funds are known as Margin, and represent a performance bond that serves to provide protection against losses in the market. Margin is the amount of money required in your trading account to go long (buy) a futures contract or go short (sell) one futures contract of a commodity. You must have the margin amount in your trading account to open a trade. See Appendix E for typical margins.

The margin is a deposit, not a cost. Commodity trading is a zero sum or cash business. Your trading account is settled at the end of each trading day with your trading account balance changing daily. Profits are deposited in your account and all losses are withdrawn from it. If you close out a trade with a profit, your margin deposit plus your profit is posted to your trading account. If your account balance falls below the maintenance amount, you will receive a margin call from your broker. This means you must release additional funds from your trading account (or deposit additional funds if your trading account amount is inadequate) to return the margin to it's original margin amount - or close your position. The Exchange collects margin directly from each of its clearing members and brokers who, in turn, are responsible for the collection of funds from their clients.

Minimum margin and maintenance amounts are established by the various commodity Exchanges. However, individual brokerages may raise these minimums at any time, without notice, and often do to protect both the trader and the broker from increased volatility. Always check with your broker for current margin amounts for a commodity you will be trading.

The Long and the Short of Trading Commodity Futures

There are two possible positions you can take in the market. You can either be long or short. These positions have multiple terms, but mean the same thing.

Going Long means you are expecting the price of a commodity to increase and you buy a futures contract of that commodity. You expect that some time in the future you can offset the contract (that is, sell the contract back) at a higher price and profit from the price increase. The expectation of an increase in price is also referred to as being Bullish.

Going Short means you are expecting the price of a commodity to decline and you sell a futures contract of that commodity. You expect that some time in the future you can offset the contract (that is, buy the contract back) at a lower price and profit from the price decrease. The expectation of an decrease in price is also referred to as being Bearish.

An objective is a target or goal that you believe price will move to. It is used to identify where you expect to exit the market, and what the approximate profit can be. It is your job to calculate the objective. This process is described in later chapters.

A. Types of Futures Contract Orders

There are numerous types of market orders which you may give to your broker. The following information describes the ones which are most commonly used.

Open Order. An order that remains in force until it is either filled, cancelled or the contract expires. Always cancel Open Orders even if they are filled and you entered the trade. The Open Order is also known as a Good-Till-Cancelled (GTC) order.

Day Order. An order that unless filled, automatically cancels at the end of the trading day. Unless otherwise specified, any order given to your broker is a Day Order by default.

Market Order. An order to buy or sell a futures contract immediately at the prevailing market price. Market Orders are considered Day Orders. That is, if your order has not been filled by the end of the trading session that day, your Market Order will be cancelled. The market order says, "get me in or get me out now".

Limit Order. An order to buy or sell a futures contract only at the specific price you state (or better). The Limit Order says, "I wish to enter this market, but only if I get my price or better".

Stop Order. An order to buy or sell a futures contract if the price moves to the price you specify. When the market does reach (or touch) that specified price, your stop order becomes a Market Order. "Buy Stop (or Sell Stop) one [month] [commodity] contract at [price]."

Stop-Loss. The same as a Stop Order except it is meant to offset an existing Order futures position (either long or short). This is an order that says if your specified price is hit, close out your position and get you out of the market. It is used to define the amount of financial risk for the trade. You continue to move your Stop-Loss Order, keeping it behind (or trailing) the current price trend. This helps protect and lock in your growing profit. Moving your Stop-Loss Order is referred to as a Cancel-And-Replace order. Never, ever have an open position without a protective Stop-Loss Order in place!

B. The Purpose of Futures Trading

To be an informed trader, it is helpful to have an understanding of how and why the futures market is used, who the market participants are, and how they conduct their business. A competitive market would be perfect if:

Many buyers and sellers met openly, with none controlling the market;
The product was standardized so all participants knew the quantity and quality which was being traded; and
Buyers and sellers could easily enter and exit the market.

While no market is perfect, futures markets come closer than most others. Because of their highly competitive nature, futures markets provide three economic benefits:

With many buyers and sellers competing freely, futures trading is an efficient way to determine the price of a commodity. This process is called price discovery.
Futures markets give producers, processors, and users of commodities a way to pass the price risk to speculating traders (that's you) who freely assume these risks. This allows the commercial users of the commodity to hedge their price risk and lower their business cost - resulting in a more efficient market with lower cost for consumers.
Because futures markets are world-wide in scope, vital market information is collected and published which helps traders make better trading decisions.

What is a Futures Contract?

A futures contract is a legally binding commitment, made through a futures Exchange, to buy (go long) or sell (go short) a futures contract. The contract describes the quantity and quality of a commodity to be delivered at a specific month in the future, and at a price agreed upon at the time the commitment is made.

Because there are different delivery months for a futures contract, each contract specifies the date which this transaction must occur, known as settlement date, and how the transaction will be fulfilled, known as delivery. If the contract is not offset (closed out) prior to the delivery date, it is settled either by the exchange of the physical commodity or in cash.

Less than 3% of futures contracts traded each year result in delivery of the underlying commodities. Instead, speculating traders generally offset their futures position before their contract expires. The difference between the entry price and the exit price at the time the contract is offset represents the realized profit or loss.

The Difference Between Cash and Forward Markets

In the days before credit was used, many stores displayed the sign, cash and carry. This meant that you pay your cash and carry away the merchandise you purchased. This is an example of the cash market.

The buyer finds the precise commodity that they want, pays their money and becomes the owner of the merchandise. It's a market system that is widely used in all forms of business to transfer title to goods.

Frequently, cash markets can be altered to meet a specific need. For example, a person who goes to the newsstand to buy a magazine may find it is more convenient to contract with the publisher for delivery at home. This modification is called a forward contract, which is used by many businesses.

The buyer and the seller agree on the product to be delivered in satisfaction to fulfill the contract. The buyer pays and the seller makes delivery. This works well when the cost of producing the commodity is known and the price is acceptable to a buyer. However, many commodities (such as coffee) compete in international markets, so there are many small producers scattered over a wide geographic area.

This makes it difficult to know what prices are available, and limits the ability of the producer, processor, and merchandiser to plan ahead. Although forward contracting can help the planning process, other things can interfere with sound planning.

This can include fragmentation of producers, uncertainty of production capacity, unfavorable weather, war, changes in interest rates, etc. This would make it difficult to determine a fair price for coffee in the forward market. Because of this, futures trading, used for grains and similar farm commodities since 1859, was adapted for coffee and other commodities to provide everyone in the market with a guide to what these commodities are worth now as well as in the future.

Determining Price

In a competitive market, both buyers and sellers interact to determine commodity price. The price at which sellers offer to sell their goods and buyers offer to buy them are based on their best assessments of the current commodity's supply and demand.

Usually, no one knows the exact supply of a commodity. This is because the production, storage and ownership of most commodities is dispersed among many people. The total production and supply for any commodity is usually an estimate so these values are not exact. Because of their international scope, many commodities are also subject to incomplete production and supply reports by other countries. However, the U.S. government reports which makes production and supply data available to the public is generally better than reports available from other countries.

Demand for a commodity is even more difficult to measure because it is based on what people may decide to buy. Price changes may alter purchasing intentions - or change whether it is even wanted it at all. An available and attractively priced substitute may change demand for the original product as well as for the related one. Futures market participants will closely monitor the price relationship for both items.

The commodity futures market prices play a vital role in our economic system and help to define our living standard. The decentralized markets serve as the "nervous system" in an economy with prices being the signals transmitted throughout the system. This lets us efficiently produce goods and control the rate of their use. Price is used to ration a commodity by influencing production and consumption. If the price is right, the production and supply of a commodity should match its use.

If the price is too high, some who plans to use a product may either use less or none at all, or they may use a substitute - for example, eat chicken instead of bacon. If enough users are priced out of the market, price will drop to encourage more use and discourage production. If the price is too low, supply will be depleted and result in a shortage. Prices will then increase to discourage some use, and will also stimulate production or attract additional supplies.

Processors and merchandisers are influenced by the price people are willing to pay for an item. They make marketing decisions based on their estimates of what consumers will buy and how much they will pay. Once in the marketing system, goods are moved from the production location to the processor and distributor and finally to the consumer. Although futures trading does not enter directly into this distribution channel, it does provide traders with information, price, and risk transfer opportunity.

Collecting Information

In an active futures market, the demand for information by traders is enormous. Futures Exchanges have evolved to become repositories for statistics on supplies, transportation, storage, purchases, exports, imports, currency values, interest rates, and other useful information. This data is constantly distributed to Exchange participants, causing traders to revise their bids and offers based on this new information. As a result, prices revisions at futures Exchanges tend to accurately reflect the supply and demand for a commodity and are used to determine cash market prices.

Discovering Prices

Price discovery is used to determine the price at which one person will buy and another will sell a futures contract. In all active futures markets, the price discovery process occurs continuously from the opening to the close of the market.

Futures markets encourage wide participation and minimizes the ability of few buyers and sellers to control price. Because futures prices are competitively determined, they are generally considered to be better price estimates than privately determined prices.

All futures contracts are standardized as to quantity and quality, so buyers and sellers only bargain over price. This allows Commercial interests to better determine cash market prices. In many commodities, futures prices have become the main reference price for those who produce, process, and merchandise a commodity. This is because the cash market and futures market prices are influenced by events that cause the price in each market to rise or fall in tandem.

There are two general types of participants in each market: Hedgers and Speculators.

Hedging (Transferring Risk)

The production and consumption of many commodities frequently results in sizable financial risk and represents a cost which affects the price of a commodity. While the uncertainty of risk cannot be eliminated, futures markets can be used by producers, processors, merchandisers and others to shift some risk to speculators who willingly accept such risk because of the opportunity for making a profit.

For over a century, many have used futures contracts as financial risk offsets to the cash market. Hedging allows a market participant to lock in prices in advance and reduce the possibility of an unanticipated loss.

Hedgers give up the chance to benefit from favorable price changes in order to gain safety from unfavorable price changes. Hedging is a technique which is used mostly by producers, processors and merchandisers. The producer uses a hedge to transfer the risk that prices may decline when a sale is made. A merchandiser uses a hedge to transfer the risk that prices may increase before a purchase is made.

The process of hedging involves the concurrent use of both cash and futures markets. Since futures and cash prices tend to move together (or similar to each other), it is possible for a cotton merchant, for example, to hedge the value of an unsold inventory of cotton with a sale of a number of futures contracts whose total value is equivalent to the value of the unsold inventory. Since the merchant owns the cotton inventory, they would incur a loss if the price of cotton declined. By selling futures contracts, the merchant obtains price loss protection. This is because if price of cotton drops, the cash market loss will be at least partially offset by the gains produced by the futures contracts. When the merchant sells their inventory at the lower cash market price, they will concurrently remove their hedge by purchasing the futures contracts at the lower price. The profit from their futures contracts should roughly equal their loss in the cash market.

Conversely, a cotton mill owner may plan to sell a quantity of cloth for delivery several months from now. However, the owner does not currently have enough cotton to produce the cloth. The owner could hedge by buying enough futures contracts to cover the forward sale of cloth. The owner now has a price for raw material to which operating and production costs can be added to arrive at a base price for the cloth.

Quoting a price before buying the cotton would make the owner vulnerable to loss of profit due to a price rise, but buying futures contracts in a quantity equivalent to their needs, the owner knows that a rise in the cost of the actual cotton will be offset by a rise in futures prices to lessen the impact of loss. The idea behind establishing equal and opposite positions in the cash and futures markets is that a loss in one market should be offset by a gain in the other market. The purpose of a hedge is not to profit, but to avoid the risk of an adverse price move which would cause major financial loss.

Hedges work because both cash and futures prices tend to move together, but they converge as each delivery month reaches expiration. Even though the difference between the cash and futures prices of silver (or gold, copper, platinum, etc.) may widen or narrow as cash and futures prices fluctuate independently, the risk of an adverse change is generally much less that the risk of going unhedged. Because the cash and futures markets do not have a perfect relationship, there is no such thing as a perfect hedge, so there will almost always be some profit or loss. However, an imperfect hedge is a much better alternative than no hedge at all in a potentially volatile market.

While a hedge transfers risk, it also denies the opportunity to financially gain from favorable price movements in the cash market. For this reason, options on futures contracts are popular among people who seek price protection, but who do not wish to miss a favorable price movement. With the payment of a premium, the buyer of an option can acquire the right, but not the obligation, to buy or sell a futures contract at a specified price until the option expires. In this way, the holder of a commodity can protect against a price drop in the value of that commodity with an option, but remain free to gain from an increase in the price of the commodity. Any such increase will be offset by the amount of the premium that was paid for the option.

Other Economic Benefits of Hedging

The ability to hedge makes it possible for producers, processors and marketers to operate on narrower profit margins. For example, if the wheat miller has protected his inventory with a hedge, he can add on his milling margin and offer a firm price to the baker. Because the hedge lessens his chance of significant loss from price change, he can sell to the baker at a lower price. The baker who also hedges can reduce his risk and lower price, passing the savings on to consumers.

Another benefit of hedging involves financing. While some bankers do not consider hedges as a factor in loans, others make it a regular policy to do so. Bankers who lend to commercial borrowers say that hedgers can borrow a greater percentage of the value of their commodity, usually at lower interest rates, than can non-hedgers. The lower cost of financing thus permits higher profit margins for the hedger and lower prices for the end-user.

What A Futures Contract Does Not Do

Futures trading is not intended as a way to transfer ownership of the commodity, so few traders deliver or take delivery on futures contracts. Cash markets normally provide the most efficient way to exchange ownership of a commodity; futures markets are a way to forward price the commodity and to lessen the risk of ownership.

Futures markets do not cause cash market prices to rise or fall. Cash and futures markets respond to the same basic supply and demand factors. Because futures trading constantly reflects expected events and readily available price information, price changes may be noticed first in the futures market. The cash market tends to respond to situations in its market area while the futures market tends to assess the broader national or international meaning of events for the months ahead, so either price may move first or furthest.

The Role of Speculators (that's You!)

Price has a rationing effect. In other words, when supplies of a commodity appear more abundant than needed, price decreases. If supplies appear to fall short of market demand, price increases. Speculators are attracted to this challenge of foretelling price direction and either buying or selling futures contracts to profit from the price change. A successful futures market includes both hedgers and speculators.

Speculation is the opposite of hedging. A speculator willingly assumes risk by trying to predict price changes before they occur, and establish a position in the market to profit from these changes. Speculators make decisions to buy or sell based on their evaluation of general price trends and other technical factors. In doing so, they help provide the risk capital that makes hedging possible.

Speculators serve an important economic function by providing liquidity to the market and also absorbing price risk. Unlike a hedger, a speculator holds no offsetting cash market position. A speculator is an additional buyer of commodities whenever it seems that market prices are lower than they should be. Conversely, when it appears that prices are too high, a speculator becomes an active seller. Frequently, speculators provide a time bridge between a hedger who wants to sell now, and a hedger who buys later. Speculators also tend to trade smaller amounts than hedgers and they also hold market positions for a shorter time.

Few speculators agree on what is too low, or too high, a price for a commodity. Some may want to sell at a particular price, others may want to buy at that price, and some may not be interested at all. Therefore, there usually are willing buyers and sellers in the market at all times.

Someone who expects a futures price to increase would buy futures contracts in the hopes of later being able to sell them at a higher price. This is known as going long. If the futures price is expected to decline, they would sell futures contracts in the hope of being able to buy back identical and offsetting contracts at a lower price. Selling futures contracts in anticipation of lower prices is known as going short. This means it is equally easy to profit from declining prices (by selling) as it is to profit from rising prices (by buying).

Most trading occurs at the market, which is the current price in the Exchange trading pit. In busy markets, there may be many resting orders for which the customer has specified an entry price. The interaction among market participants, and the activation of resting orders causes prices to move up and down to widen or narrow the carrying charge. The result of this action is an active and liquid market.

How To Read Commodity Futures Price Tables In Investor's Business Daily

Price is the key statistic generated by futures markets. The trading Volume and the number of outstanding contracts (Open Interest) also are important. Price is available from a variety of sources, including many daily newspapers.

Because of the superior coverage of the futures industry which is provided by Investor's Business Daily, their format is used in this trading course. The following table shows what the futures data looks like in Investor's Business Daily. This example shows the futures Corn data for Friday, December 18, 1998. Note: The data in the newspaper is the previous day's data.

 
Table 2-1

   Season                    Open
High     Low               Interest   Open     High     Low     Close    Chg
CORN (CBOT) - 5,000 bu minimum- cents per bushel

299.50   196.00   Dec 98     4,273    216.50   216.75   212.75  213.00  - 2.75
305.00   209.50   Mar 99   172,538    223.25   225.00   220.25  220.75  - 2.50
299.00   217.00   May 99    46,167    230.50   232.00   227.75  228.00  - 2.50
312.00   223.50   Jul 99    52,360    237.00   238.00   234.00  234.25  - 2.00
280.00   232.00   Sep 99    10,489    241.75   243.25   240.75  240.75  - 1.25
291.50   238.00   Dec 99    26,434    247.25   248.00   246.00  246.25  - 0.75
Est. Vol. 54,000 Vol. 33,210 open int 316,483 - 21

The first and second lines at the top of the table read as follows:

The Season High and Low refer to the highest and lowest prices recorded for each contract from the first day it was recorded to the present.

Open Interest is the number of outstanding contracts for each maturity month. Some newspapers do not include this information.

The Open or opening price is the price or range of prices for the day's first trades, registered during the period designated as the opening of the market or the opening call. In the table shown, December 1998 Corn on the Chicago Board of Trade (CBOT) opened at 216.50 (two hundred sixteen and one-half cents, that is, $2.16-½) per bushel. Many publications print only a single price for the market open or close regardless of whether there was a range with trades at several prices.

The word High refers to the highest price at which the commodity sold during the day. The high price for December 1998 Corn was $2.16-¾ (that is, two dollars, sixteen and three-quarter cents) per bushel.

Low refers to the lowest price at which the commodity sold during the day. The low price for December 1998 Corn was $2.12-¾ per bushel.

The Close (closing price) is the last price used when the Exchange ceased trading for that day. December 1998 Corn closed at 213.00 ($2.13 per bushel).

Because the last few minutes of trading are often the busiest part of the day, with many trades occurring simultaneously, the exchange clearing house computes a settlement price from the range of closing prices. The settlement price, which is abbreviated settle in most pricing tables, is used by the clearing house to determine margins for its members. It is also frequently used synonymously with closing price, although they may, in fact, differ.

The Chg (change) refers to the change in the previous day's close to the current day's close. The -2.75 change for December 1998 Corn indicates that yesterday's settlement price must have been 215.75 (i.e., 213.00 + 2.75).

At the bottom of the table is another line of information. Est.Vol. indicates the estimated volume of trading for that day was 54,000 contracts. Vol. means that the actual trading volume was 33,210 contracts. Open Int. refers to the total open interest for all contract months combined at the end of the day's trading session. The 316,483 open contracts represent a decrease (-21) of 21 contracts from the open interest of the previous day at the close.

The third line from the top of the table reads as follows:

Corn (CBOT) 5,000 bu; cents per bu. This line means that the table applies to the Chicago Board of Trade (CBOT) Corn contract; the contract size is 5,000 bushels; and the prices shown in the table are in units of cents per bushel. Thus, 263.00 (two hundred sixty three cents) means $2.63 per bushel.

The next chapter covers the Commodity Futures Trading Contract Specifications.