Post on 01-Jan-2016
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
– 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 Sell@4.04/bu $0.03/bu
FUTURES:SPREADING EXAMPLE
• Correct forecast scenario, prices rise
KCBT CBOT Spread
Apr. 15 Buy @4.07/bu Sell@4.04/bu $0.03/bu
Sep. 20 Sell back Buy back @4.57/bu @4.47/bu $0.10/bu
FUTURES:SPREADING EXAMPLE
• Correct forecast scenario, prices rise
KCBT CBOT Spread
Apr. 15 Buy @4.07/bu Sell@4.04/bu $0.03/bu
Sep. 20 Sell back Buy back @4.57/bu @4.47/bu $0.10/bu
Gain (Loss) $0.50/bu (–$0.43/bu)
NET GAIN $0.07/bu (minus broker commissions)
FUTURES:SPREADING EXAMPLE
• Correct forecast scenario, prices fall
KCBT CBOT Spread
Apr. 15 Buy @4.07/bu Sell@4.04/bu $0.03/bu
FUTURES:SPREADING EXAMPLE
• Correct forecast scenario, prices fall
KCBT CBOT Spread
Apr. 15 Buy @4.07/bu Sell@4.04/bu $0.03/bu
Sep. 20 Sell back Buy back @3.57/bu @3.47/bu $0.10/bu
FUTURES:SPREADING EXAMPLE
• Correct forecast scenario, prices fall
KCBT CBOT Spread
Apr. 15 Buy @4.07/bu Sell@4.04/bu $0.03/bu
Sep. 20 Sell back Buy back @3.57/bu @3.47/bu $0.10/bu
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
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
rofi
ts p
er
Un
it o
f C
om
mo
dit
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
er
Un
it o
f C
om
mo
dit
y
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
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 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
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 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:
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 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
SHORT HEDGEExample 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 HEDGEExample 1: MIDDLEMEN
• 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
SHORT HEDGE Example 1: MIDDLEMEN
• Scenario 1: Prices FALL
SPOT FUTURES BASIS ACTIVITY ACTIVITY
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 FUTURES BASIS ACTIVITY 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 + Futures Gain (Loss) = Net Selling Price
$4.25 + $1.80 = $6.05
as expected
SHORT HEDGE Example 1: MIDDLEMEN
• Scenario 2: Prices RISE
SPOT FUTURES BASIS ACTIVITY ACTIVITY
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 FUTURES BASIS ACTIVITY 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 + 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)