Commodity Futures Markets: How They Work August 2005

Introduction
A commodity exchange is a central meeting place where buyers and sellers meet to do business. The exchange provides the facilities where buying and selling takes place. The exchange itself does not buy or sell commodities or contracts, nor does it set or establish prices. A commodity exchange performs three valuable functions. 1) It sets rules and regulations to promote uniform practices between buyers and sellers in the market. 2) It provides the machinery for settlement of business disputes. 3) It instantly circulates valuable price and market information to exchange members, their customers and other interested market participants. Buying and selling of commodities, such as wheat or cattle or canola, may be done in two ways. They can be bought or sold in either the cash market or the futures market, which are two separate but related markets. The cash or "spot market is where the actual, physical commodities are bought and sold at a price negotiated between buyer and seller. The futures market is different from the cash market. In the futures market, legally binding futures agreements - not the actual commodities themselves - are bought and sold. These agreements are called futures contracts because they provide for the delivery of or receipt of a specified amount of a particular commodity during a specified future month. Futures contracts do not involve immediate transfer of ownership of the commodity. Instead, futures contracts involve actual receipt or delivery of the commodity at some future date. For this reason, you can buy and sell commodities in a futures market whether or not you own that commodity. Some of the terms specific to futures trading are explained throughout this module.

Organized Commodity Exchanges

Hundreds of futures contracts are traded on exchanges in the United States, Canada and around the world. Listed below are the North American exchanges where agriculture commodity futures and futures important to agriculture are traded. All of these exchanges also trade options on most of the futures listed. This list was compiled in August 2005. Check exchange Web sites for greater detail on these contracts or for new or discontinued contracts. Chicago Board of Trade (CBOT) - http://www.cbot.com/ -Corn, U.S. and South American soybeans, soybean oil, soybean meal, soft red winter wheat, rough rice and ethanol as well as mini-size contracts of corn, soybeans and soft red winter wheat. Chicago Mercantile Exchange (CME) - http://www.cme.com/ -Live cattle, feeder cattle, lean hogs, frozen pork bellies, diammonium phosphate, liquid urea aommonium nitrate, urea, two classes of manufacturing milk, powdered skim milk, Grade AA butter and a large number of foreign currencies including Australian Dollar, Brazilian Real, British Pound, Canadian Dollar, Czech Koruna, Euro, Hungarian Forint, Japanese Yen, Mexican Peso, New Zealand Dollar, Norwegian Krone, Polish Zloty, Russian Ruble, South African Rand, Swedish Krona, and Swiss Franc. Kansas City Board of Trade (KCBOT) - http://www.kcbt.com -Hard red winter wheat.

Minneapolis Grain Exchange (MGEX) - http://www.mgex.com/ -Hard red spring wheat delivered to Minneapolis/St. Paul and cash-settled hard red spring, hard red winter, soft red winter wheat, corn and soybeans. New York Board of Trade (NYBOT) - http://www.nybot.com -Coffee (C), sugar (#11 and #14), cocoa, frozen concentrated orange juice, cotton (#2) and major currencies exchange rate differentials Winnipeg Commodity Exchange (WCE) - http://www.wce.ca -Canola, domestic feed wheat, western feed barley and flaxseed. As of the end of August, 2005, WCE flaxseed futures have not traded actively for some months. It is possible that trading of flaxseed futures at the WCE will be delisted, which means flaxseed futures will no longer be available for trading.

The Commodity Clearing House

All commodity exchanges use a clearinghouse to handle the bookkeeping of trading futures and options contracts. The clearinghouse is responsible for keeping records of all trades between all buyers and sellers by acting as a third party go-between on all buys and sells. In other words, the clearinghouse acts as a seller to all buyers and the buyer to all sellers once the original buyers and sellers names and the price are reported for the trade. After each day's trading, all exchange members must report their buys and sells to the clearinghouse. The clearinghouse then ensures that financial settlement from all buyers and sellers is made to the clearinghouse. In addition, the clearinghouse guarantees all contrasts by requiring that all participants maintain cash deposits, called margins or margin money, with the clearinghouse. In Canada, the Winnipeg Commodity Exchange Clearing Corporation (WCECC) operates the clearinghouse for the WCE. The WCECC is a limited liability company composed of shareholders who must also be members of the Exchange. The shareholders of the clearing house are required to provide performance bonds (margin money) as well as contribute to a guarantee fund to ensure the clearing house will be able to meet all commitments to any buyer or seller, regardless of the financial situation of any trader. In addition to maintaining an accounting of each trader's holdings of contracts, the clearinghouse will cancel out the trader's obligation on a contract if the trader has offset his obligation to someone else. (For a further explanation of offset see 'Contract Obligations: Delivery of Offset' below.) As soon as a contract, that has been traded in the trading pit, has been processed by the clearinghouse, each party effectively has a contract with the clearinghouse instead of the actual party the original trade was made with. This makes it easier for either party to offset a futures market position, since neither has to find and deal with the party with whom the original trade was made. The clearinghouse enables one party to liquidate or offset a position without requiring the other party to the original trade to offset as well.

The Futures Contract

Futures contracts are highly standardized, legally binding documents. Contracts are standardized to simplify trading. Futures contracts specify the commodity, the quantity, the grade, the delivery or price reference point, the delivery period, and the delivery terms. Details of the Winnipeg Western Barley futures contract is shown on Table 1 and explained in detail below the table.

Table 1. WCE Western Barley Futures Contract - Effective December 2002 and later contracts Contract Quality: 48 pounds per bushel (300 grams/0.5 litre), 14.8% maximum moisture, 2% maximum dockage, other specifications to meet #1 CW Barley 46 pounds per bushel (288 grams/0.5 litre), 14.8% maximum moisture, 2% maximum dockage, other specifications to meet #1 CW Barley 44 pounds per bushel (276 grams/0.5 litre), 14.8% maximum moisture, 2% maximum dockage, other specifications to meet #1 CW Barley Board Lot - 100 tonnes Job Lot - 20 tonnes 9:30 a.m. to 1:15 p.m. Central Time March, May, July, October, December on truck, at the buyers facility, Lethbridge 10 cents per tonne $7.50 per tonne above or below previous days close trading day preceding the fifteenth calendar day of the delivery month

Discount ($5.00/t):

Discount ($15.00/t):

Contract Units: Trading Hours: Contract Months Delivery Point or Price Reference Point: Minimum Price Change Daily Trading Limit: Last Trading Day

Contract Commodity
Identifying the commodity is straightforward. The name of the futures contract is the commodity traded.

Contract Quality
Most contracts specify one grade of the commodity. Often, however, other specified grades are allowed to be delivered at a premium or discount to the contract price. Price differentials are established based on those usually found in the cash or "spot market. See Table 1 for a partial list of Western Barley futures discounts and premiums.

Contract Units
Western Barley futures contracts are traded in 20-tonne and 100-tonne units, called a job lot and a board lot, respectively. Chicago Board of Trade wheat, soybean, corn, and oats contracts are traded in 5,000-bushel lots.

Contract Months
Each futures contract has a number of contract or delivery months. Table 1 lists Western Barley futures contract months.

Delivery or Price Reference Points

Delivery or price reference points are important for the proper functioning for each futures contract. These points are designated by the exchange. For example, for the WCE Western Barley futures contract, the primary delivery point, and the price reference point, is on-truck at Lethbridge. That means that all buyers and sellers of Western Barley futures know that they are negotiating a price for barley delivered to, but still on the truck, at Lethbridge.

Exchanges may also determine alternative delivery points. Using the same example of Western Barley, actual delivery of barley on a futures contract can also be made, on-truck, at any location within Alberta, Saskatchewan or Manitoba. If the seller of a Western Barley futures contract decides to deliver barley against futures at, say Calgary, the actual price he/she receives for the barley is the futures price he/she sold futures at less an exchange-designated discount roughly related to the barley cash price difference between Calgary and Lethbridge. Subject to certain rules established by the exchange, delivery of the actual commodity against a futures contract is at the seller's choosing. The Western Barley contract contract specifies a range of deliverable grades, a place of delivery, and a delivery period. The seller, however, chooses the particular grade, exact location, and day of actual delivery.

Daily and Expanding Trading Limits

Commodity exchanges set trading limits to maintain an orderly market and prevent price changes from becoming excessive. These limits keep prices from advancing or declining beyond a certain range from the previous day's closing price. The closing price is the price at which futures traded immediately before the end of the trading day. These ranges differ for different contracts. For Western Barley, for example, the daily limit is $7.50 per tonne. If Western Barley closes the trading day at $128 per tonne, it may rise to $135.50 per tonne or fall to $120.50 per tonne the next trading day, but no higher or lower. The maximum daily trading range, therefore, is $15/ tonne or twice the trading limit. Trading in a commodity does not necessarily stop as soon as the limit is hit. As long as there are buyers and sellers, activity can continue right at the limit. Under certain conditions, when markets are extremely volatile, and limit price advances or declines occur, exchanges may allow daily limits to be expanded. There are no expanded limits allowed for any futures contracts traded at the WCE. Some exchanges do not have trading limits on the current or "spot" month. The "spot' month means, for example, a December futures contract trading in December.

Last Trading Day

Every futures contract has a day that is the last day that it can be traded, known as the Last Trading Day. In Western Barley, the Last Trading Day is the trading day preceeding the fifteenth calendar day of the delivery month. For example, the last trading day for May, 2005, Western Barley is Friday, May 14. However, if May 15th were to be a Sunday, the Last Trading Day would be May 13. No new May, 2005, contract positions can be opened after the last trading day and no contracts can be offset after that day.

Contract Obligations: Delivery or Offset

A holder of a buy" or sell futures contract has two choices of how to deal with the legal obligations of a futures contract before the last trading day of the delivery month. Those legal obligations may be met 1) by a seller actually delivering the commodity to the buyer or by a buyer taking delivery of the commodity or 2) by 'offsetting' the contract. The quality and location specifications of futures contrasts discourages, but does not prevent, making or taking delivery for most users. However, a vast majority of futures contracts are dealt with by offset. In an offset, the futures contract holder takes an equal but opposite position to the original trade, canceling the obligation. For example, a person having sold a five, February 05 Live Cattle

contracts, could cancel or offset that sell position by buying five February 05 Live Cattle contracts. The clearinghouse, which keeps track of everyone's futures contracts, sees the obligation to make delivery (the 'sell' futures) as offset, or cancelled, by an obligation to take delivery (the "buy" futures). In the Live Cattle contract example, above, the holder of the February sell contract can usually offset his/her contract at any time up to the contract's last trading day. The last trading day for a February Live Cattle contract is the last business day of July. If, in this case, the sell contract is not offset before the end of trading on the last day of July, the sell contract holder would actually be legally obligated to deliver slaughter cattle to someone holding a July buy contract. It is usually not wise to wait until a futures expiry month to offset a futures position, especially for contracts traded at the WCE. Futures trade in an expiry month may be thin so a trader may have difficulty offsetting a position. As well, expiry-month prices may move quite differently than prices of other futures months of the same commodity.

Margin
Commodity futures transactions are margin transactions. In other words, the buyer of a futures contract is only required to put up a fraction of the total value of the specified commodity purchased. Margin money is essentially a guarantee that the person (trader) will honor the contract entered into. There are two types of margins - the initial margin and the maintenance margin. The minimum amount of the initial margin is set by the exchange and varies depending on the commodity, the commodity's contract value, and how much and how quickly prices move up and down. The actual initial margins for most traders are set by futures commission merchants and are often higher than the minimums set by the exchange. If a change in the futures contract price causes the contract to lose money, a margin call may be required by the broker. A margin call is required once an account's initial margin has been reduced by a certain amount, generally 20 percent or more. If this happens, the client must deposit enough money to bring the account's margin up to original requirements. If no money is deposited on the day of the margin call or early the next morning, the traders commodity broker will automatically make an offset trade to terminate the client's futures position. Brokers will offset, in this case, to protect the brokerage house which is legally responsible to cover losses if a trader doesnt or isnt able to cover the losses. For example, in Example 1 below, Client A buys one soybean futures contract (5,000 bushels) for, say, $5.62 per bushel. Client A must post an initial margin of $1,000 with the broker. If, the next day, the price of that soybean contract goes down by 10 cents a bushel, to $5.52, Client A has a potential loss of $500 (5000 bushels X $0.10). Client A's margin account has been reduced by the $500 potential loss to only $500 ($1,000-$500). To bring Client A's account back to the required margin level, the commodity broker asks the client to send $500 to bring the margin account up to $1000. This is known as a margin call. Example 1 June 3 June 3 June 4 June 4 Client A buys one Jan. soybean contract (5,000 bushels) buy Jan. soybean futures @ $5.62/bu. Initial Margin Jan. soybean futures price @ $5.52/bu Potential Loss (if offset) $.10/bu $1000

June 4 June 4 June 4

Potential Loss Margin Account Value Margin Call from Broker Margin Account Value

-$500 $ 500 Margin Call (money sent to broker) $ 500 $1000

(5000 bu. X $0.10) =

A Futures Trading Example

In mid-June, a speculator expects canola prices will rise over the next few months based on his belief that the upcoming crop will be smaller than most people expect. (See Example 2.) Through a commodity broker, he/she buys a 100 tonne November canola contract on the WCE for $390 per tonne. This buy is known as taking a long futures position. Remember that since futures contracts are margin transactions, the speculator only needs to put up a fraction of the total value of the contract (about four to five per cent) as margin. In early July, November canola futures are trading at $410 per tonne and the speculator decides to take profits ($20 per tonne) and instructs his broker to sell 100 tonnes November canola futures. The new short (sell) position offsets the original long (buy) obligation. What remains is to square up any gains or losses from price changes since the original futures position was opened. In this example, the speculator bought 100 tonnes of November canola at $320 per tonne, sold 100 tonnes for $340 per tonne for a gross gain of $20 per tonne. From this gross sum, broker commissions must be paid. There were no margin calls because the speculator saw prices move in a favorable direction (the way the speculator expected) only. Example 2 June 10 June 10 July 7 July 7

initial margin deposit with broker buy 100t Nov Canola at sell (offset) 100t Nov Canola at Gross Profit Funds returned to trader: $20/t (profit) + $15.00/t (margin) - $1.25/t (broker commission)

$15.00/ t $390/t $410/t $ 20/t

= $33.75/t

Trading Futures
Futures contracts can only be traded through Futures Commission Merchants (FCMs) commonly known as Commodity Brokers. A Market Clippings newsletter entitled 'Choosing a Commodity Broker, available on Ropin the Web at http://www1.agric.gov.ab.ca/$department/deptdocs.nsf/all/sis1015?opendocument gives suggestions on how to choose a broker and lists FCMs licensed to operate in Alberta at the time of writing.

Additional Information
All of the major commodity exchanges listed above offer a large amount of educational material on their web sites at no cost or for a fee in printed hardcopy. The material is usually listed under the Education or Publications links on exchange home pages. Many bookstores, particularly on-line stores, such as Chapters.Indigo.ca, offer a very large selection of books on how the futures and options markets work and the mechanics and strategies of trading them.