Workshop on Agricultural Commodity Futures and Options Speaker
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1 Workshop on Agricultural Commodity Futures and Options Speaker Dr. Wade Brorsen Oklahoma State University
2 Open Outcry AKA The Pit
3 Futures trading is increasingly electronic.
4 Ways to Reduce Risk Futures Contract Contract for future delivery traded on organized futures exchange and that specifies quality standards, delivery specifications, delivery locations, etc.
5 Betting Analogy $50 for each cent/bushel Zero-sum game
6 Common Questions Question How can you sell something you don t own? How can there be more corn futures than there is corn?
7 Why do Futures Markets Exist?
8 Who Participates in Futures Markets? Hedgers Middlemen (Cargill, feedlots, elevators) Producers Speculators Scalpers (floor traders, high frequency traders) Technical Fundamental
9 Futures Markets Reduce price risk Have low transaction costs Are middlemen s markets
10 Benefits of Futures to Consumers Allocate crops across the year Lower marketing margins
11 Ways to Reduce Risk Futures Cash Forward Contracts Options Swaps
12 Ways to Reduce Risk Cash Forward Contract Actual delivery of the commodity
13 Ways to Reduce Risk Options Insurance on Price
14 Ways to Reduce Risk Swaps OTC derivatives
15 Who Regulates the Chicago Mercantile Exchange? Commodity Futures Trading Commission (CFTC)
16 Not to be confused with: Commodity Futures Trading Commission (CFTC) Securities and Exchange Commission (SEC)
17 Not to be confused with: Commodity Futures Trading Commission (CFTC) Securities and Exchange Commission (SEC) Federal Trade Commission (FTC)
18 Workshop on Agricultural Commodity Futures and Options Speaker Andew McKenzie University of Arkansas
19 Futures Contracts Contracts are settled in 3 ways: Physical delivery (deliver a commodity at the futures price) Offsetting (sell and then buy back) Cash settled (S&P 500)
20 To Go Long If I buy a futures contract I am agreeing to physically accept delivery of the commodity
21 To Go Short If I sell a futures contract I am agreeing to physically deliver the commodity
22 Corn Futures Contract at Chicago Board of Trade (CBOT) are Standardized Standardization Components: 1. Contract Size specific quantity 1 corn contract = 5,000 bushels (127 Metric Tons) 2. Deliverable Grade specific grade #2 Yellow at contract Price #1 Yellow at a 1.5cent/bushel premium #3 Yellow at a 1.5 cent/bushel discount
23 Corn Futures Contract at Chicago Board of Trade (CBOT) are Standardized Standardization Components: 3. Contract Delivery time of delivery Months March, May, July, September and December 4. Deliverable Location physical location Chicago warehouses or grain elevators
24 Mechanics of a Futures Trade
25 To Go Long is to Buy Futures Contracts LONG - Buy CORN $6.00 per bushel (size) 5 DECEMBER (delivery) Illinois River(location)
26 To Go Long is to Buy Futures Contracts LONG - Buy CORN $6.00 per bushel (size) 5 DECEMBER (delivery) Illinois River(location)
27 To Go Long is to Buy Futures Contracts Long futures positions make a profit when prices go up $6.20 $6.00 Time
28 To Profit From the Trade an Offsetting Short or Sold Position is Taken Short - Sell CORN $6.20 per bushel (size) 5 DECEMBER (delivery) Illinois River(location)
29 Offsetting the Position The two positions cancel out: LONG - Buy CORN $6.00 per bushel (size) 5 DECEMBER (delivery) Illinois River(location) Short - Sell CORN $6.20 per bushel (size) 5 DECEMBER (delivery) Illinois River(location)
30 Calculating Profit From the Trade Sold Short Price $6.20 per bushel Less Bought Long Price $6.00 per bushel $0.20 per bushel
31 Total Profit = $0.20 per bushel (Price per bushel change) X 5,000 bushels (units in a contract) X 5 contracts (number of contracts) Total Profit = $5,000
32 An Example of Going Short
33 Traders can first Sell or Short Contracts Hoping to Profit From a Fall in Prices SHORT Sell 5 DECEMBER CORN at $6.00 per bushel
34 To Close Out or Offset the Trade a Long or Bought Position is Taken LONG Buy 5 DECEMBER CORN at $6.20 per bushel
35 Again, the Two Positions Cancel Out SHORT Sell 5 DECEMBER CORN at $6.00 per bushel LONG Buy 5 DECEMBER CORN at $6.20 per bushel
36 Profit From the Trade Sold Short Price $6.00 per bushel Less Bought Long Price $6.20 per bushel $0.20 per bushel LOSS!
37 Total Loss = -$0.20 per bushel (Price per bushel change) X 5,000 bushels (units in a contract) X 5 contracts (number of contracts) Total Loss = $5,000
38 Talk to Your Neighbor Scenario: You buy 1 December corn futures contract at a price of $7 per bushel. (Assume you offset your position at a price of $6.50 per bushel.) What is your trading profit in dollars?
39 Total Loss = -$0.50 per bushel (Price per bushel change) X 5,000 bushels (units in a contract) X 1 contracts (number of contracts) Total Loss = ($2,500)
40 The Intersection Between Futures and Cash Markets
41 How Are Futures and Cash Markets Connected? BASIS Time Grade Location Cash Price Futures Price
42 BASIS The Difference Between the Cash and Futures Price $13.20 $14.10 Local Price -$0.90 Can be Negative Market Price
43 BASIS The Difference Between the Cash and Futures Price $14.10 $13.20 Local Price +$0.90 Can be Positive Market Price
44 Futures and Cash Prices Move Closely Over Time Futures Price Basis Cash Price SEP OCT NOV DEC JAN FEB MCH APR MAY JUN JUL AUG
45 Futures and Cash Prices Converge To the Same Price at Delivery Time Futures Price Storage Costs Cash Price Delivery Time for July Corn Futures SEP OCT NOV DEC JAN FEB MCH APR MAY JUN JUL AUG
46 Delivery Time July Corn Futures are Turned into Physical Bushels of CASH Corn At a Physical Delivery Location (Grain Elevator or Warehouse)
47 Delivery Time So, at the Delivery Location Futures and Cash Prices come Together or Converge Cash Price Futures Price
48 At Delivery Time You Can t Have 2 Different Prices For 1 Thing in the Same Place! Cash Price = Futures Price
49 What Accounts For Difference Between Cash and Futures Prices in Non-delivery Locations? Futures Price Transportation costs Storage Costs Cash Price Delivery Time for July Corn Futures SEP OCT NOV DEC JAN FEB MCH APR MAY JUN JUL AUG
50 What Accounts For Difference Between Cash and Futures Prices in Non-delivery Locations? Futures Price Transportation costs Storage Costs Cash Price Storage Costs Delivery Time for July costs Corn Futures Transport SEP OCT NOV DEC JAN FEB MCH APR MAY JUN JUL AUG BASIS
51 How are Futures and Cash Markets Connected? 1. Because Over Time, Cash and Futures Prices Move Together 2. Because At Delivery, Cash and Futures Prices Converge to the Same Value Futures Markets can be Used to Offset Price Risk Through Hedging
52 Managing Risk Hedging Taking a futures position that is equal and opposite a cash position.
53 Who Practices Hedging? A Feedlot Manager Feedlot Manager Actions Buy feeder cattle Buy corn Sell live cattle
54 Hedging In Action
55 Hedging In Action
56 Calculate Forward Contract Price Elevator s bid for corn delivered in fall =$3.20/bushel. Today's forward corn basis = $-0.45/bushel.
57 Calculate Expected Sale Price Elevator s bid for corn delivered in fall =$3.20/bushel Expected BASIS at harvest = $-0.40/bushel Forward Contracting Cost = $ 0.05/bu. Futures Price = $ 3.65/bu.
58 Calculate Expected Sale Price Futures Price = $ 3.65/bu. Expected Basis = $-0.40/bu. Expected Sale Price =$ 3.25/bu.
59 The Hedge is Offset When (Assumption) Futures Price= $ 3.40/bu. Actual Basis = $-0.33/bu.
60 Managing Risk Options
61 Ways to Reduce Risk Futures Cash Forward Contracts Options Swaps
62 Ways to Reduce Risk Options Definition
63 Options Buying a CALL option allows a trader to buy futures at a fixed price. If futures prices increase the CALL makes a profit.
64 Options Buying a PUT option allows a trader to sell futures at a fixed price. If futures prices decrease, the PUT makes a profit.
65 Options Hedging is Like Insurance For firms buying commodities, CALLS can be used to fix the maximum purchase price. For firms selling commodities, PUTS can be used to fix the minimum sale price.
66 Special Topics
67 Farm Programs Target prices Free options Shallow loss provision Option collar
68 Fund Trading Index Funds Long only Managed Funds Trend Following
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