Becoming Familiar With the Futures Market Section Advanced

Becoming Familiar With the Futures Market • Section: Advanced Agribusiness • Unit: Marketing • Lesson Title: Becoming Familiar With the Futures Market

Becoming Familiar With the Futures Market 1. 2. 3. 4. 5. 6. Define the futures market and its functions and understand the functions of the futures exchange. Define a futures contract and understand its standardized terms. Describe the different futures market participants. Understand the clearing house and margins. Describe the difference between short and long contracts. Describe carrying charges.

Objective 1: Defining the Futures Market

Objective 1: Defining the Futures Market • The Futures Market is defined as: The process of trading futures contracts and operating the facilities that market many Ag products.

The Functions of the Futures Market Objective 1: 1. Provide an efficient and effective mechanism for the management of price risk. 2. Provide an efficient mechanism for price discovery. 3. Provide a source of information for decision making. 4. Provide a means for firms to secure additional operating capital.

The Functions of the Futures Exchange Objective 1: 1. To bring together in a central place a large number of buyers and sellers. 2. To establish and enforce trading rules and standards. 3. To settle disputes. 4. To collect and disseminate marketing information to the public.

Objective 1: • Define the futures market. • Functions of the futures exchange.

Objective 2 Define a futures contract and understand its standardized terms

Define a futures contract o A legally binding commitment to make or take delivery of a standardized quantity and quality of a commodity at a predetermined place and time in the future, for a price determined by auction in the trading pit of an exchange o Price is determined by open outcry. o Open outcry is when bids are shouted in a pit. o The benefit of open outcry is that it is competitive price discovery.

Define A Futures Contract Cont. There are two ways that a futures contract can be settled. o Delivery o Less than 1% of all contracts traded is delivered on. o Offsetting. o Means to do the opposite of what you had previously done. o Example: if you had previously bought a contract, you sell it back. If you had sold one, then you buy it back.

Standardized Terms 1. 2. All terms for a futures contract are standardized, EXCEPT the price. 1. The price again is found by open outcry in the trading pit. The standardized terms include the following: 1. 2. Delivery month – 1. month of contracts. 2. For example: March, May, July, September, December. Contract Size – 1. Unit size of the contracts. 2. For Example: Grains are 5000 bu; Feeder cattle are 50000 lbs and live cattle (fat Cattle) are 40000 lbs

Standardized Terms Cont. 3. Place of delivery – o if delivered on the par delivery point. 4. Minimum Price fluctuations – o minimum movement in the price. o for example: ¼ cent in grains. 5. Maximum daily price move – 1. Maximum it can move in one day. 2. for example 30 cents in wheat.

Objective 2 • Define a Futures contract. • Standardized Terms.

Think, Pair, Share

Objective #3 Describe the different futures market participants

Objective 3: Describe the different futures market participants 1. There is a difference between traders and brokers: 1. Traders 1. buy and sell contracts for him or her self – does not take customer orders. 2. Brokers 1. take customers orders; may trade for him or her self, but first responsibility is his customer.

Objective 3: Describe the different futures market participants 1. We can classify the people who are the futures market participants into several different categories. The general public that trades would be in the last two categories: either public speculators or hedgers. 1. Floor brokers: fill orders for outside speculators and hedgers. 2. Professional Speculators: trade for own accounts. 3. Scalpers – buys and sells minute by minute. 4. Pit traders – take larger positions and hold for longer, but usually not overnight.

Objective 3: 5. Describe the different futures market participants. Floor traders – take large positions and hold for several days. 6. Hedgers: Producers or users of commodities who seek protection against adverse price changes by taking a futures position opposite to cash position. 7. Public speculators: Place orders with brokers to profit from anticipated price changes. Not necessarily interested in owning the commodity, but only in profiting off movements in the price.

Objective 3 • Different Futures Market Participants. – Traders, Brokers • Floor Brokers • Professional Speculator • Scalper • Pit Trader • Floor Trader • Hedgers • Public Speculators

Objective 4 Understand the clearinghouse and margins

Understand the clearinghouse and margins Objective 4: • Clearing House o Assumes the opposite side of every trade so that all connections between buyers and sellers are served. o Because the number of buys = number of sells, the clearing house has no net position.

Objective 4: Margins 1. To trade you must have an account. 2. With every new trade, traders must deposit money called margin. 3. Margins serves as a deposit. 4. Initial margin: initial deposit paid. 5. Maintenance Margin: minimum amount of money that must be kept in accounts. 6. Margins are NOT a COST for trading futures. Your margin money is a deposit in your account and if your trade is not a losing trade, you will still have your margin money. 7. The clearing house “marks-to-market” all open positions at the end of a day to adjust all accounts.

Objective 4: Margins Cont. 8. Margin Call – when the equity in the traders account falls below the maintenance margin level. 9. Must then deposit enough funds to bring the equity in the account back to the initial margin level.

Objective 4 • Clearinghouse • Margins

Little Professor Moment Teach to your partner

Objective 5: Describe the difference between short and long positions.

Objective 5: Short Position The term to sell is also known as a short position. To be short means that you are trying to protect the commodity in your possession from falling prices. Producers are generally sellers of short position holders. Short = Sell = Protect from falling prices = producer.

Objective 5: Long Position • The term to buy is also known as a long position. To be long means that you are trying to protect the purchase price of a commodity that you plan on obtaining from rising prices. Mills, Factories, and packers would be long position holders • Long = Buy = protect from increasing prices = Mills, factories, packers

Simple Rule: • Buy Low and Sell High in either order

Objective 5 • Short Position • Long Position • Simple Rule

Objective 6: Describe carrying charges

Describe carrying charges 1. Carrying Charge = the difference in the prices from one futures contract to another.

Normal Market 1. Normal Market = is nearby price is lower than the distant contract price – so prices increase into the future. It reflects the cost of storage. For example, if the nearby month is Dec and the Dec price is 2. 32 and the March price 2. 39 and the May price is 2. 44 and the July Price is 2. 48 and the Sept price is 2. 57 then the market is normal. 2. Is common when supplies are large. 3. Tells the trader what the market will pay for storage. 4. Futures price spreads rarely reflect full carrying charge.

Inverted Market 1. Inverted Market = 1. nearby prices are higher than distant contract prices – So prices decrease into the future. 2. It reflects a negative price of storage. In other words, we are in short demand of the product so the market price is telling you that they will pay a premiums if the product is delivered now – do not store the product until later. 3. For example, if Dec is the nearby month again, but this time the Dec price is 2. 32, the March price is 2. 28, the May price is 2. 20, the July price is 2. 16, and the Sept price is 2. 10, now the market is inverted.

Inverted Market Cont. 4. Usually prevails when supplies are small. 5. Market says they will pay a premium if you deliver now. 6. Reflects negative price of storage.

Objective 6 • Carrying Charge • Normal Market • Inverted Market

Review and Summary

Now You Should Be Able To: 1. 2. 3. 4. 5. 6. Define the futures market and its functions and understand the functions of the futures exchange. Define a futures contract and understand its standardized terms. Describe the different futures market participants. Understand the clearing house and margins. Describe the difference between short and long contracts. Describe carrying charges.

Any Questions

Quiz 1. Define the futures market. 2. What are the four main functions of a futures market? 3. What are the four main functions of a futures exchange? 4. What is a futures contract? 5. Price is determined by ________ 6. What is open Out cry? 7. What are the two ways a futures contract can be settled?

Quiz 8. What are the 5 standardized terms of a futures contract? 9. Who are the participants in the futures market? 10 What is a Clearinghouse? 11. What is the purpose of the clearinghouse? 12. What is a Margin? 13. What is a Maintenance Margin? 14. What is a Short Position? 15. Who is most likely to take a Short Position? 16. What is a Long Position?

Quiz 17. Who is most likely to take a Long Position? 18. What is a normal market and give an example of a Normal Market? 19. What is an Inverted Market and give an example of such a market? 20. What is the simple rule to follow when making trades on the futures market?