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
FUTURES: SPECULATION
• “Spreaders” simultaneously buy
and selling in two related markets in
the expectation of making a profit
when positions are offset
FUTURES: SPECULATION
•
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
Spread KCBT-CBOT = $4.07/bu – $4.04/bu
= $0.03/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/bu
2. “Offset” (i.e., sell back) the spread sometime before December
(hopefully, for more than $0.03/bu)
FUTURES:
SPREADING EXAMPLE
• Correct forecast scenario, prices rise
KCBT
Apr. 15
CBOT
Spread
Buy @4.07/bu Sell@4.04/bu $0.03/bu
FUTURES:
SPREADING EXAMPLE
• Correct forecast scenario, prices rise
KCBT
Apr. 15
Sep. 20
CBOT
Spread
Buy @4.07/bu Sell@4.04/bu $0.03/bu
Sell back
@4.57/bu
Buy back
@4.47/bu
$0.10/bu
FUTURES:
SPREADING EXAMPLE
• Correct forecast scenario, prices rise
KCBT
Apr. 15
CBOT
Spread
Buy @4.07/bu Sell@4.04/bu $0.03/bu
Sep. 20
Sell back
@4.57/bu
Gain (Loss) $0.50/bu
NET GAIN
Buy back
@4.47/bu
$0.10/bu
(–$0.43/bu)
$0.07/bu
(minus broker commissions)
FUTURES:
SPREADING EXAMPLE
• Correct forecast scenario, prices fall
KCBT
Apr. 15
CBOT
Spread
Buy @4.07/bu Sell@4.04/bu $0.03/bu
FUTURES:
SPREADING EXAMPLE
• Correct forecast scenario, prices fall
KCBT
Apr. 15
Sep. 20
CBOT
Spread
Buy @4.07/bu Sell@4.04/bu $0.03/bu
Sell back
@3.57/bu
Buy back
@3.47/bu
$0.10/bu
FUTURES:
SPREADING EXAMPLE
• Correct forecast scenario, prices fall
KCBT
Apr. 15
CBOT
Spread
Buy @4.07/bu Sell@4.04/bu $0.03/bu
Sep. 20
Sell back
@3.57/bu
Buy back
@3.47/bu
Gain (Loss) (–$0.50/bu)
$0.57/bu
NET GAIN
$0.10/bu
$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
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
Spot and Futures prices
BASIS: GENERALITIES
Far
Futures
Spot
Nearby
Futures
1.20
Nearby Expiration
0
Time
Far Expiration
ISM Lean Hog Basis
$90
Spot
$80
Basis
$70
Average
Std Dev
Min
Max
$30
$20
Spot
58.63
13.71
15.36
88.47
Basis
-1.97
3.99
-15.12
12.33
2/27/98
$40
2/27/97
$50
$10
$$(10)
2/27/04
2/27/03
2/27/02
2/27/01
2/27/00
2/27/99
2/27/96
$(20)
2/27/95
$/cwt Carcass
$60
BASIS: GENERALITIES
• For storable commodities at delivery
location:
Current Futures Price  Current Spot price
+ Storage Cost
• Hence:
– Basis  - Storage Cost
BASIS: GENERALITIES
• Basis generally follows seasonal
patterns
– Grains typically widest at harvest then
narrow until the next harvest
– Livestock varies, but follows the tendencies
• Seasonal spot price
• Converging at expiration
1Fe 15
b
1M 15
ar
11
Ap 5
r1
-1
M
5
ay
115
Ju
n
115
Ju
l1
Au 15
g
1Se 15
p
115
O
ct
115
N
ov
115
D
ec
115
n
Ja
Iowa Live Cattle Basis, 2002-2005 ($/cwt)
$5
$4
$3
$2
$1
$-
$(1)
$(2)
$(3)
$(4)
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 hedgers
1 Sell the futures contract initially
2 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
Net Profits per Unit of Commodity
4
3
Production
Cost
2
1
0
0
1
2
3
4
5
6
-1
-2
-3
Spot Price at Time of Selling Commodity
Position Diagram:
Net Profits for Short Position in Futures
Net Profits per Unit of Commodity
4
3
Futures Price
at which Short
Position is Open
2
1
0
-1
0
1
2
3
4
-2
-3
-4
Futures Price at Time of Offsetting
5
6
Long Hedgers
• Processors or feeders that plan to buy a
commodity in the future
– Are hurt by a price increase
• Long hedgers
1 Buy the futures initially
2 Sell the futures contract (offset) when they
buy the physical commodity
LONG HEDGE:
WHY DOES IT WORK?
Position Diagram:
Net Profits for Short Spot Position
4
Net Profits per Unit of
Commodity
3
Revenue
2
1
0
-1
0
1
2
3
4
5
6
-2
-3
Spot Price at Time of Buying Commodity
Position Diagram:
Net Profits for Long Position in Futures
Net Profits per Unit of Commodity
4
Futures Price
at which Long
Position is Open
3
2
1
0
-1
0
1
2
3
4
-2
-3
-4
Futures Price at Time of Offsetting
5
6
FUTURES: HEDGING
• Short (Selling)
Hedge
• Long (Buying)
Hedge
– Protects from
FALL in spot price
– Protects from
RISE in spot price
– “Locks in” a
SELLING 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
Preharvest short hedge example
• 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 example
Step 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
Preharvest short hedge example
• 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 Prices
Dec Corn futures =
Basis as expected
Cash corn
Futures position loss
$2.50 - 3.00 -0.01
Net price
$3.00
-$0.25
$2.75
-$0.51
$2.24
Hedging example Lower Prices
Dec Corn futures =
Basis as expected
Cash corn
Futures position gain
$2.50 - 2.20 -0.01
Net price
$2.20
-$0.25
$1.95
+$0.29
$2.24
Hedging example Basis Change
Dec 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
Local basis
Commission
Expected hedge price
$2.70
-.25
+.01
$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:
Currently July corn trading at
$2.90
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:
Currently July corn trading at
$2.30
Local basis
-.25
Cash price
$2.05
Futures position loss
$2.30 - 2.70 -0.01
-$0.41
Net price
$2.46
SHORT HEDGE
Example 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
SHORT HEDGE
Example 1: MIDDLEMEN
• 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
SHORT HEDGE
Example 1: MIDDLEMEN
Expected profits from storage
= $6.05/bu – $5.75/bu – $0.13/bu
= $0.17/bu
• Storage is expected to be profitable
BUT
Risky because price of soybeans may fall
• Decision: Storage and short hedge
SHORT HEDGE
Example 1: MIDDLEMEN
MAR
SPOT
ACTIVITY
FUTURES
ACTIVITY
Buy @ $5.75
Sell Aug. @ $6.30
BASIS
Expected -$0.25
SHORT HEDGE
Example 1: MIDDLEMEN
• Scenario 1: Prices FALL
SPOT
ACTIVITY
FUTURES
ACTIVITY
BASIS
MAR
Buy @ $5.75
Sell Aug. @ $6.30
Expected -$0.25
JUL
Sell @ $4.25
Buy back @ $4.50
Actual -$0.25
SHORT HEDGE
Example 1: MIDDLEMEN
• Scenario 1: Prices FALL
SPOT
ACTIVITY
FUTURES
ACTIVITY
MAR
Buy @ $5.75
Sell Aug. @ $6.30
Expected -$0.25
JUL
Sell @ $4.25
Buy back @ $4.50
Actual -$0.25
Spot Price
+
$4.25
+
BASIS
Futures Gain (Loss) = Net Selling Price
$1.80
=
$6.05
as expected
SHORT HEDGE
Example 1: MIDDLEMEN
• Scenario 2: Prices RISE
SPOT
ACTIVITY
FUTURES
ACTIVITY
BASIS
MAR
Buy @ $5.75
Sell Aug. @ $6.30
Expected -$0.25
JUL
Sell @ $7.50
Buy back @ $7.75
Actual -$0.25
SHORT HEDGE
Example 1: MIDDLEMEN
• Scenario 2: Prices RISE
SPOT
ACTIVITY
FUTURES
ACTIVITY
MAR
Buy @ $5.75
Sell Aug. @ $6.30
Expected -$0.25
JUL
Sell @ $7.50
Buy back @ $7.75
Actual -$0.25
Spot Price
+
$7.50
+
BASIS
Futures Gain (Loss) = Net Selling Price
(-$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)