| | Introduction | Organized commodity exchanges | Commodity clearing house | Futures contract | Delivery or price reference points | Daily trading limits | What to do with futures contracts | Margin | Additional information | Return to Marketing Principles page
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This is an updated fact sheet from the Economics and Marketing section of the Alberta Feedlot Management Guide, Second Edition published September 2000. The 1200 page guide is available for purchase on CD-ROM.
.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, in the form of contracts, 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 the listed 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 ammonium 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://quotes.ino.com/exchanges/contracts.html?r=NYBOT_KC
-Coffee (C), sugar (#11 and #14), cocoa, frozen concentrated orange juice, cotton (#2) and major currencies exchange rate differentials
IntercontinentalExchange - https://www.theice.com/clear_canada.jhtml
-Canola, domestic feed wheat, western feed barley and flaxseed.
-WCE flaxseed futures have not traded actively since December 7, 2004. On September 8, 1995, the WCE de-activated flaxseed futures from trading. It is likely that trading of flaxseed futures at the WCE will be delisted - 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 buyer's and seller's 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.
At the WCE, the Winnipeg Commodity Exchange Clearing Corporation (WCECC) operates the clearinghouse. 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 trade position. (For a further explanation of "offset" see 'Contract Obligations: Delivery or Offset' below.) As soon as a contract that has been traded, 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 one 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. For example, details of the Winnipeg Western Barley futures contract are 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 |
| Discount ($5.00/t): | 46 pounds per bushel (288 grams/0.5 litre), 14.8% maximum moisture, 2% maximum dockage, other specifications to meet #1 CW Barley |
| Discount ($15.00/t): | 44 pounds per bushel (276 grams/0.5 litre), 14.8% maximum moisture, 2% maximum dockage, other specifications to meet #1 CW Barley |
| Contract Units: | Board Lot - 100 tonnes Job Lot - 20 tonnes |
| Trading Hours: | 9:30 a.m. to 1:15 p.m. Central Time |
| Contract Months | March, May, July, October, December |
| Delivery Point or Price Reference Point: | on truck, at the buyers’ facility, Lethbridge |
| Minimum Price Change: | 10 cents per tonne |
| Daily Trading Limit: | $7.50 per tonne above or below previous day’s close |
| Last Trading Day: | trading day preceding the fifteenth calendar day of the delivery month |
Contract commodity
Identifying the commodity is straightforward. The name of the futures contract is the commodity traded. In this case it is Western Barley.
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, in 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 originally sold futures at less an exchange-designated discount roughly related to the typical 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. In other words, the seller has the right to make delivery even if the buyer doesn't wish to accept delivery. The Western Barley 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.
Currency and units
The currency the contract is traded in and the units of measurement. In this case, it is Canadian dollars per tonne.
Contract months
Each futures contract has a number of contract or delivery months. Table 1 lists Western Barley futures contract months.
Contract size
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 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 par contract price. The "par" quality is the quality before discounts or premiums. Price differentials are established based on those usually found in the cash or "spot" market. See Table 1 for a list of Western Barley futures discounts and premiums.
Trading hours
This describes the opening (beginning) and closing (ending) times for trading of the particular futures contract.
Minimum price change
Each futures contract has a minimum price change that traders may buy or sell at. For Western Barley futures, traders may only bid or offer prices that are10 cents per tonne, not five cents or eight cents, above or below a previously bid or offered price.
Daily 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. These ranges differ for different contracts. (See "Settlement of Closing Price" below.)
For Western Barley, for example, the daily limit is $7.50 per tonne. If Western Barley closes the trading day at $128 per tonne, the next trading day it may rise to $135.50 per tonne or fall to $120.50 per tonne, 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 a limit up or down 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" or "expiry" month. The "spot" or "expiry" month means, for example, a December '05 futures contract trading in December '05. For example, Canadian Dollar futures traded on the CME have no limits for trades during a spot or expiry month.
First notice day
First Notice Day is the first day that someone holding a sell contract may notify the clearing house, through their broker, that he or she intends to deliver against that contract.
First delivery day
First Delivery Day is the first day that someone holding a sell contract may actually delivery the commodity against that futures contract.
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 (at the time or writing), the Last Trading Day is the trading day preceding the 15th calendar day of the delivery month. For example, the last trading day for May '05, 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.
Settlement or closing price
During trading on any business day, the price of most futures contracts will usually fluctuate up and down several or many times as sellers try to sell at the highest price possible and buyers try to buy at the lowest price possible. At the end of the trading period, from 1:14 pm to 1:15 pm at the WCE for instance, most actual trades take place over a very narrow range of prices.
Sometimes, at the close, however, few or no actual trades take place and there may be a difference between the bid (the price buyers have offered to pay) and the ask (the price sellers want to receive).
In either case, after trading has ended, the Clearing House studies the end-of-day bids and offers or asks and determines what the settlement price for the futures contracts will be. The settlement price is more commonly known as the "closing price".
What do Do with Futures Contracts
A holder of "buy" or "sell" futures contracts has several choices of how to deal with the legal obligations of a futures contract before the last trading day of the delivery month. The two most common ways of dealing with futures contracts are
- by a seller actually making delivery of the commodity to the buyer or by a buyer taking delivery of the commodity - called making or taking delivery
- by "offsetting" the contract.
Other much-less commonly used ways of dealing with "buy" or "sell" futures contracts are:
3. Exchange for Physical, and
4. Exchange for Risk.
In making delivery, the seller of a futures contract actually delivers the commodity to a buyer of the futures contact. For example, let's say that a canola grower from near Saskatoon sold five Nov 05 contracts (100 tonnes) on March 16, 2005 at $302.00 per tonne. On November 2, 2005, he decides to deliver 100 tonnes of canola "against" the five Nov '05 contracts to an elevator in Saskatoon. He or she initiates the process by contacting his commodity broker. The broker begins the process by notifying the WCE Clearing House of the intended delivery. Making delivery of canola "against" a futures contract must be done at certain elevators designated by the WCE as "regulars". The grower is responsible for all the costs of getting the canola to the elevator plus the costs of inward elevation at the elevator. Once the process has been completed, the grower will receive $302.00 per tonne for his canola provided it grades #1 and has no more than eight per cent dockage. This example is a significant over-simplification of the delivery process but it gives the basic concept of making delivery "against" futures. The quality and location specifications of futures contrasts and the complexity of the delivery process discourages, but doesn't prevent, a seller from making delivery or a buyer from taking delivery in many cases.
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 who has sold five February '05 Live Cattle contracts, could cancel or "offset" that sell position by buying five February '05 Live Cattle contracts at a later date. 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 or her contract at any time up to the last trading day of the contract. The last trading day for a February '05 Live Cattle contract is the last business day of February '05. If, in this case, the "sell" contract is not offset before the end of trading on the last day of February '05, the "sell" contract holder would actually be legally obligated to deliver slaughter cattle to someone holding a February '05 "buy" contract.
Important note
It is usually not wise to wait until a futures contract's expiry or spot 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.
Other modules in this manual will deal with making delivery, offsetting trades, exchange for physical and exchange for risk in more detail.
Registered futures commission merchant responsibilities
Neither individuals nor most companies can buy and sell futures contracts directly through commodity exchanges. The persons who place buy and sell futures contract orders for, say, barley or canola growers and users, are called registered futures commission merchants (RFCMs), although most people call them brokers or commodity brokers. (For more information, see Choosing a Commodity Broker).
Margin
Commodity futures transactions are margin transactions. In other words, the buyer or seller of a futures contract is only required to deposit part of the total value of the specified commodity future that is bought or sold. Margin money, required by regulations set out by each commodity exchange, must be deposited with a RFCM before a futures contract is first bought or sold. Margin money is essentially a guarantee that the trader, the customer of the RFCM, will honor the contract entered into.
There are two levels of margins - the initial margin and the maintenance margin. The minimum amount of the initial margin is set by the exchange and varies depending a number of factors. The initial margin depends on the commodity, the commodity's contract value or trading price, and how much and how quickly prices move up and down. Exchanges may increase or decrease initial margin amounts at any time .
The actual minimum initial margins for most traders are set by the exchange. However, RFCMs set often initial margins higher by than the minimums set by the exchange. The maintenance margin is the minimum amount of money that must be maintained in a margin account after all potential losses have been accounted for. Table 2 shows recent WCE minimum initial and maintenance margins.
If a change in the futures contract price causes the contract to lose money, even though the contract has not been offset, a "margin call" may be required by the broker. A margin call is required once an account's initial margin has been reduced to below the maintenance margin or 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 the maintenance margin requirements. If no money is deposited on the day of the margin call or early the next morning, the trader's 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 firm which is legally responsible to cover losses if a trader doesn't or isn't 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, Margin Call
June 3 Client A buys one Jan. soybean contract (5,000 bushels)
@ $5.62/bu. Initial Margin $1000
June 4 Jan. soybean futures price falls to close at $5.52/bu
June 4 Potential Loss per bushel (if offset) $.10/bu
Total Potential Loss (5000 bu. X $0.10) = -$500
June 4 Margin Account Value - after accounting for potential loss $500
June 4 Margin Call (phone call) from Broker $500
June 4 Margin Call Made (money sent to broker) $500
June 4 Margin Account Value $1000
A futures trading example, example 2
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 prices moved in a favorable direction (upward, the way the speculator expected) only.
Example 2
June 10 initial margin deposit with broker $15.00/ t
June 10 buy 5 contracts (100t) Nov Canola at $390/t
July 7 sell (offset) 100t Nov Canola at $410/t
Gross Profit $ 20/t
July 7 Funds returned to trader:
$20/t (profit) + $15.00/t (margin)
- $1.25/t (broker commission) = $33.75/t
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 in printed hardcopy for a fee. The material is usually listed under the "Education" or "Publications" links on exchange home pages.
Many bookstores, including on-line stores, such as Chapters.Indigo.ca or Amazon.ca, offer a very large selection of books on how the futures and options markets work and the mechanics and strategies of trading them.
RFCMs, or commodity brokers, often have a large amount of material available for prospective customers. |
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