Long and Short Hedging Lab
Long Hedging Lab
Margin Account Lab
Short-Hedging Lab
Understanding Hedging with Futures Contracts
Overview
This unit takes the ideas learned in Understanding Commodity Markets and Understanding Basis and digs deeper to explain how futures contracts are used to allow agricultural producers to hedge.
Futures Markets
Futures Markets
Futures markets for commodities serve two primary functions that are vital and of extreme importance to farmers, ranchers and producers; price discovery and risk management. The link to the website below offers a video to watch and is a great example of how the CME Group performs both functions:
The CME Group is the parent company to the two most famous futures markets in the world – the Chicago Mercantile Exchange (CME) and the Chicago Board of Trade (CBOT). There are other futures markets – Minneapolis Grain Exchange (MGEX), Kansas City Board of Trade (KCBOT), New York Mercantile Exchange (NYMEX), Intercontinental Exchange (ICE). Each exchange offers a market to trade (buy or sell) futures contracts for different commodities. For example, the MGEX offers a platform for hedgers and speculators to buy and sell futures contracts as well as options on futures contracts on hard red spring wheat, where the CBOT offers the market for soft red winter wheat and the KCBOT offers the market for hard red winter wheat. All three wheat classes have differing uses as well as differing growing regions. HRSW is primarily grown in the norther plains (North Dakota, South Dakota, Montana, northern Minnesota, and the Pacific Northwest), SRWW is primarily grown in the Midwest and upper Midwest (Michigan, Indiana, Illinois, and Ohio), HRWW is primarily grown in the central plains (Kansas, Oklahoma, Nebraska, Texas, and Colorado). This doesn’t mean that HRWW cannot be grown in states like North Dakota, it is, however, the primary region is in the central plains. That is also why the major markets for the trading of those commodities are located in the cities that they are located in. Years ago, they became the major hubs for the grain to get processed into food products for consumption.
What are Futures Contracts?
One of the things that gets confused often is what exactly a futures contract is. Before we fully explain that concept lets focus on a cash contract. When a producer signs a cash contract (sells cash grain) they are promising to deliver a certain quantity of a certain grade of a commodity to a specific location by a certain date where they will receive an agreed upon price. Once the producer has delivered on that contract (hauled the specified quantity of the promised quality to the location agreed upon by the date agreed to) the buyer of the contract is obligated to settle the contract by paying the seller the agreed price. Futures contracts are not contracts made with your local cash purchaser. Futures contracts are actually much simpler. Take corn for example. If you want to sell a corn futures contract on the CBOT, you will be selling 5000 bushels of number 2 yellow dent corn, delivered to Chicago, IL by the expiration date of that contract. Which is why there are multiple months that corn futures contracts trade (March, May, July, September and December of each year). Say you sell a July futures contract today – May 19th 2020, since the contract already specifies that it is for 5000 bushels of #2 yellow dent corn delivered to Chicago by July 14th, 2020, the only other item that needs negotiated on the contract is the price.
Negotiating price is why price discovery works in futures markets. Because thousands and thousands of contracts get traded each day on the CBOT in corn, we have an accurate representation of what the overall market feels is the correct price for corn in the US. Remember that the only negotiated component on a corn futures contract is the price! All of the other components of the contract are fixed. Click the link below to go to the current contract specifications for corn futures that are traded on the CBOT:
https://www.cmegroup.com/trading/agricultural/grain-and-oilseed/corn_contract_specifications.html
The delivery component to futures contract is generally where most people get hung up. Truth be told, delivery occurs in very few instances (less than 2% of contacts traded). How is this possible? To fully grasp this concept, try not to think of selling a futures contract as selling something right now at this moment, and focus more on making a “promise” to sell something in the future. Remember, when we sell July 2020 Corn today (May 19th, 2020) I am not actually selling any corn to anyone today, I’m selling a piece of paper – a contract – a futures contract (or a promise to deliver in the future) to someone that may or may not actually want those 5000 bushels in July. As long as I buy back the exact same contract – a July 2020 Corn futures at some point between now and July I remove my obligation to deliver corn to Chicago in July. That is why futures contracts get delivered on in less than 2% of traded contracts. Most sellers buy back their obligations to make a delivery and likewise most buyers sell their obligation to take delivery before the contract expires.
The key is to think of futures contracts as pieces of paper that promise to make (sell) or take (buy) delivery of the commodity by a certain date. Rather than actually delivering or taking delivery of physical bushels in the cash market. This concept coupled with basis – the fact that futures and cash markets are linked together are what make the second purpose of futures markets possible –price risk management.
Futures Markets Labels
Futures markets use a system to label and abbreviate futures contracts. Since there are several commodities that are being traded on different exchanges and each commodity is trading in several different months, there needs to be a system that abbreviates the contracts so that they can be referred to easily and simply. The issue is that you almost need to work in the brokerage business to remember them. It is not expected that you will remember every single contract abbreviation, but you do need to know how to figure out what contract is being talked about. The following tables will help out:
For the delivery month, refer to the table below:
For commonly traded agricultural commodities, refer to the table below:
Code | Commodity |
MW | Minneapolis Wheat – Hard Red Spring Wheat - HRSW |
C | Corn |
S | Soybeans |
ZW | Chicago Wheat – Soft Red Winter Wheat - SRWW |
KW | Kansas City Wheat – Hard Red Winter Wheat - HRWW |
M | Soybean Meal |
L | Soybean Oil |
GF | Feeder Cattle – 700 lb steer |
GL | Live Cattle – Fat steer ready for slaughter – over 1300 lbs |
H | Lean Hogs – hog carcass – already slaughtered hanging on rail |
Again, you are not expected to memorize these contract codes. But when you work through the labs, often the futures contracts will be listed in there abbreviated codes, so you will need to be able to figure out what it is that you are working with. Referring to the “Contract Specifications” link above will help as well.
Lab Activity – See “Futures Contract Specifications” below.
Hedging – The Short Hedge
Hedging – The Short Hedge
We have talked about hedgers and hedging in previous units. Hedgers are traders that will have to buy or sell the physical commodity and are looking to “hedge” or lock in their prices in order to remove risk. At any point the producers might look at the price of December 2020 Corn futures and decide that they like the price being offered in the futures markets. They are able to “hedge” their position by taking an opposite position in the futures market as they have taken in the cash market. What position have they taken in the cash market – well the producer has bought the seed, the chemical, the fertilizer, paid the land rent, purchased the equipment and paid for all of the other input requirements to get the crop in the field so that they will be able to harvest corn in the fall, and then sell it in the cash market. The farmer is what is known as “long the cash”. Meaning they have bought the cash inputs and now need to sell the cash crop – corn. Since they are “long” in the cash market and the definition of hedging is taking the opposite position in the futures market, they would need to sell or “short” the futures market. Below is a table to illustrate what is occurring in this example:
| Cash Market | Futures Market | Basis |
May 2020 | $3.00. Offered for forward contract with local buyer – Does NOT sell to local buyer | $3.50. Sells December 2020 Corn futures | -$0.50 |
November 2020 | $2.50. Sells corn in the spot market to the local buyer. | $3.00. Buys back December 2020 Corn futures | -$0.50 |
The basis for cash corn delivered to the local buyer in December of 2020 does not change during the course of this example. What does change is the December 2020 Corn futures price. In May it was trading at $3.50/bu. and in November it has traded down to $3.00/bu. Because of this the cash price offered to the farmer in December is now 50 cents less than they would have received if they had sold the forward contract back in May. Instead the farmer “short hedged” or sold December 2020 Corn futures at a price of $3.50/bu. In November the farmer is able to buy back the December 2020 Corn futures contract at $3.00 – pocketing or profiting $0.50/bushel. Remember that a corn futures contract is 5000 bushels which means that the farmer profits a total of $2500. The farmer then sells the physical bushels in the cash market at the current cash price - $2.50/bu., but since they had short-hedged and earned a $0.50/bu. gain their “Net Sales Price” (NSP) is equivalent to $3.00/bu.:
| Cash Market | Futures Market | Basis |
May 2020 | $3.00 – December Forward Contract | $3.50. Sells December 2020 Corn futures | -$0.50 |
November 2020 | $2.50 | $3.00. Buys December 2020 Corn futures | -$0.50 |
|
| Cash Price Received | $2.50 |
|
| Gain/Loss on Futures | +$0.50 |
|
| Net Sales Price | $3.00 |
Now let’s see what happens when the basis changes or adjusts during the time of the problem. Let’s assume that basis for December delivery is at -$0.70 by the time the farmer delivers corn to the local buyer:
| Cash Market | Futures Market | Basis |
May 2020 | $3.00 – December Forward Contract | $3.50. Sells December 2020 Corn futures | -$0.50 |
November 2020 | $2.30 | $3.00. Buys December 2020 Corn futures | -$0.70 |
|
| Cash Price Received | $2.30 |
|
| Gain/Loss on Futures | +$0.50 |
|
| Net Sales Price | $2.80 |
Now let’s assume that basis for December delivery is at -$0.10 by the time the farmer delivers corn to the local buyer:
| Cash Market | Futures Market | Basis |
May 2020 | $3.00 – December Forward Contract | $3.50. Sells December 2020 Corn futures | -$0.50 |
November 2020 | $2.90 | $3.00. Buys December 2020 Corn futures | -$0.10 |
|
| Cash Price Received | $2.90 |
|
| Gain/Loss on Futures | +$0.50 |
|
| Net Sales Price | $3.40 |
Now let’s assume that basis for December delivery is at +$0.20 by the time the farmer delivers corn to the local buyer:
| Cash Market | Futures Market | Basis |
May 2020 | $3.00 – December Forward Contract | $3.50. Sells December 2020 Corn futures | -$0.50 |
November 2020 | $3.20 | $3.00. Buys December 2020 Corn futures | +$0.20 |
|
| Cash Price Received | $3.20 |
|
| Gain/Loss on Futures | +$0.50 |
|
| Net Sales Price | $3.70 |
One thing to note is how in all of the examples the Net Sales Price is always equal to the Futures price when the hedge was entered +/- the basis at the time the hedge is “lifted” (exited, bought back):
| Cash Market | Futures Market | Basis |
May 2020 | $3.00 – December Forward Contract | $3.50. Sells December 2020 Corn futures | -$0.50 |
November 2020 | $2.50 | $3.00. Buys December 2020 Corn futures | -$0.50 |
|
| Cash Price Received | $2.50 |
|
| Gain/Loss on Futures | +$0.50 |
|
| Net Sales Price | $3.00 |
| Cash Market | Futures Market | Basis |
May 2020 | $3.00 – December Forward Contract | $3.50. Sells December 2020 Corn futures | -$0.50 |
November 2020 | $2.30 | $3.00. Buys December 2020 Corn futures | -$0.70 |
|
| Cash Price Received | $2.30 |
|
| Gain/Loss on Futures | +$0.50 |
|
| Net Sales Price | $2.80 |
| Cash Market | Futures Market | Basis |
May 2020 | $3.00 – December Forward Contract | $3.50. Sells December 2020 Corn futures | -$0.50 |
November 2020 | $2.90 | $3.00. Buys December 2020 Corn futures | -$0.10 |
|
| Cash Price Received | $2.90 |
|
| Gain/Loss on Futures | +$0.50 |
|
| Net Sales Price | $3.40 |
| Cash Market | Futures Market | Basis |
May 2020 | $3.00 – December Forward Contract | $3.50. Sells December 2020 Corn futures | -$0.50 |
November 2020 | $3.20 | $3.00. Buys December 2020 Corn futures | +$0.20 |
|
| Cash Price Received | $3.20 |
|
| Gain/Loss on Futures | +$0.50 |
|
| Net Sales Price | $3.70 |
Lab Activity – See “Short-Hedging Lab” below.
Hedging – The Long Hedge
Hedging – The Long Hedge
The buyers of the commodities often times need protection as well, only this time from higher prices that might occur in the future. Assume that an ethanol plant needs to buy corn to process into ethanol in September. It could purchase corn in the spot market today and store it until it is needed, but that costs money to store grain, and they might not have enough storage available to hold that much corn. They could also forward contract the purchase for delivery when it is needed. Or they can long hedge their purchases. Remember that hedging is taking an opposite position in the futures market as you currently hold in the cash market. The ethanol plant is “short” the cash market. They will need corn in the future, but currently do not have it available to them. Since the are “short the cash” they will hedge that cash position by taking a long position in the futures market. To do so they go and buy September 2020 Corn futures today at $3.25/bu. Below is a table that illustrates what is occurring in this example:
| Cash Market | Futures Market | Basis |
May 2020 | $3.00. Offered for forward contract with local seller – Does NOT buy from local buyer | $3.25. Buys September 2020 Corn futures | -$0.25 |
September 2020 | $2.50. Buys corn in the spot market from the local seller. | $2.75. Buys back December 2020 Corn futures | -$0.25 |
The basis between May and September for a September delivery forward contract does not change and remains at 25 under. What does change in this example is that the September 2020 Corn futures price drops between May and September. This is actually not good for the buyer of corn. As you will see in the following table, they lose money in the futures as a result of this long hedge position:
| Cash Market | Futures Market | Basis |
May 2020 | $3.00 – September Forward Contract | $3.25. Buys September 2020 Corn futures | -$0.25 |
September 2020 | $2.50 | $2.75. Sells September 2020 Corn futures | -$0.25 |
|
| Cash Price Paid | $2.50 |
|
| Gain/Loss on Futures | -$0.50 |
|
| Net Purchase Price | $3.00 |
One tricky part to this problem is how we handle the loss on the futures position. You might notice that we had to pay $2.50/bu. to buy the cash corn in the spot market. We also lost $0.50/bu. in the futures market. So how in the world do we end up with a $3.00/bu. net purchase price? Shouldn’t we subtract the 50-cent loss? That is what we would have done in the short hedge problem! The answer is no. In all of these problems you need to focus on the direction of the money flow. In this problem, the ethanol plant has to pay their corn supplier for the corn that they are purchasing - $2.50/bu. They also lose $0.50/bu. in their futures account. Technically both amounts are negative cash flows. Both the $2.50/bu. paid for cash corn and the $0.50/bu. futures loss is paid to someone else, which means the “Net” of the transactions is a loss of $3.00/bu. for the ethanol plant. Now, it is NOT a loss, as they gain corn, an ingredient that is vital to the production of ethanol. And while it is true, they would have been better off to not hedge and just purchase the corn in the spot market when they needed it, markets don’t always do what we want them to do. That is why it is called price risk management. For the purchaser of commodities, the risk is that the price could go up, so to remove that risk they long-hedge. Removing the price risk but creating a scenario where the price could go lower and they would miss out on it. For the seller of commodities, the risk is that the price could go down, so to remove that risk they short hedge. Removing price risk but creating a scenario where the price could go higher, and they miss out on the higher prices.
Now lets see what happens when the basis changes or adjusts during the time of the problem. Let’s assume that basis for September delivery is at -$0.70 by the time the ethanol plant buys corn from the local supplier:
| Cash Market | Futures Market | Basis |
May 2020 | $3.00 – September Forward Contract | $3.25. Buys September 2020 Corn futures | -$0.25 |
September 2020 | $2.05 | $2.75. Sells September 2020 Corn futures | -$0.70 |
|
| Cash Price Paid | $2.05 |
|
| Gain/Loss on Futures | -$0.50 |
|
| Net Purchase Price | $2.55 |
Now let’s assume that basis for September delivery is at -$0.10 by the time the ethanol plant buys corn from the local supplier:
| Cash Market | Futures Market | Basis |
May 2020 | $3.00 – September Forward Contract | $3.25. Buys September 2020 Corn futures | -$0.25 |
September 2020 | $2.65 | $2.75. Sells September 2020 Corn futures | -$0.10 |
|
| Cash Price Paid | $2.65 |
|
| Gain/Loss on Futures | -$0.50 |
|
| Net Purchase Price | $3.15 |
Now let’s assume that basis for September delivery is at +$0.30 by the time the ethanol plant buys corn from the local supplier:
| Cash Market | Futures Market | Basis |
May 2020 | $3.00 – September Forward Contract | $3.25. Buys September 2020 Corn futures | -$0.25 |
September 2020 | $3.05 | $2.75. Sells September 2020 Corn futures | +$0.30 |
|
| Cash Price Paid | $3.05 |
|
| Gain/Loss on Futures | -$0.50 |
|
| Net Purchase Price | $3.55 |
Again one thing to note is how in all of the examples the Net Purchase Price is always equal to the Futures price when the hedge was entered +/- the basis at the time the hedge is “lifted” (exited, bought back):
| Cash Market | Futures Market | Basis |
May 2020 | $3.00 – September Forward Contract | $3.25. Buys September 2020 Corn futures | -$0.25 |
September 2020 | $2.50 | $2.75. Sells September 2020 Corn futures | -$0.25 |
|
| Cash Price Paid | $2.50 |
|
| Gain/Loss on Futures | -$0.50 |
|
| Net Purchase Price | $3.00 |
| Cash Market | Futures Market | Basis |
May 2020 | $3.00 – September Forward Contract | $3.25. Buys September 2020 Corn futures | -$0.25 |
September 2020 | $2.05 | $2.75. Sells September 2020 Corn futures | -$0.70 |
|
| Cash Price Paid | $2.05 |
|
| Gain/Loss on Futures | -$0.50 |
|
| Net Purchase Price | $2.55 |
| Cash Market | Futures Market | Basis |
May 2020 | $3.00 – September Forward Contract | $3.25. Buys September 2020 Corn futures | -$0.25 |
September 2020 | $2.65 | $2.75. Sells September 2020 Corn futures | -$0.10 |
|
| Cash Price Paid | $2.65 |
|
| Gain/Loss on Futures | -$0.50 |
|
| Net Purchase Price | $3.15 |
| Cash Market | Futures Market | Basis |
May 2020 | $3.00 – September Forward Contract | $3.25. Buys September 2020 Corn futures | -$0.25 |
September 2020 | $3.05 | $2.75. Sells September 2020 Corn futures | +$0.30 |
|
| Cash Price Paid | $3.05 |
|
| Gain/Loss on Futures | -$0.50 |
|
| Net Purchase Price | $3.55 |
Lab Activity – See “Long Hedging Lab” below.
Hedging – Locking in Prices
Hedging – Locking in Prices
Often times you will hear hedging referred to as locking in prices. And essentially that is what you are doing. Remember that your cash price that you receive if selling grain or pay if buying grain is always a function of the futures market. That is the local cash price is derived somehow from the futures price that is quoted every second of the trading day. The only thing that we are not able to hedge is the basis. When we place a hedge, we are subject to the basis changing between the date we place the hedge and the date we lift the hedge and buy or sell the physical commodity in the cash market. Thus, hedging transfers all of the price risk from the futures market to the basis market. In all four of the examples for both the short-hedge and the long-hedge the price that we entered the futures hedge at remained constant, the only thing that changed the Net Price was the basis.
That is why hedging is known as “locking in prices”. Essentially the buyer or seller decides that they can live with that price, places the hedge, and if the market moves against their position, they are OK with the futures loss because the cash market is offsetting the loss. In the case of the short hedger, as the futures price increases, they are suffering a loss in the futures market. However, since the cash market is derived from that same futures price, their cash price is increasing and offsetting the loss they are incurring in the futures market. See example below:
| Cash Market | Futures Market | Basis |
May 2020 | $3.00 – December Forward Contract | $3.50. Sells December 2020 Corn futures | -$0.50 |
November 2020 | $3.50 | $4.00. Buys December 2020 Corn futures | -$0.50 |
|
| Cash Price Received | $3.50 |
|
| Gain/Loss on Futures | -$0.50 |
|
| Net Sales Price | $3.00 |
Had the farmer in the example above done nothing, they would be selling cash corn at $3.50/bu. Since the farmer hedged, they lost 50 cents in the futures market. While that stinks, the farmer made a calculated decision that they were “good with” selling $3.00 corn (given an expected -50 basis). Had the market moved the opposite way, the farmer would have felt like a genius:
| Cash Market | Futures Market | Basis |
May 2020 | $3.00 – December Forward Contract | $3.50. Sells December 2020 Corn futures | -$0.50 |
November 2020 | $2.00 | $2.50. Buys December 2020 Corn futures | -$0.50 |
|
| Cash Price Received | $2.00 |
|
| Gain/Loss on Futures | +$1.00 |
|
| Net Sales Price | $3.00
|
In this example the market drops placing the hedge in a profitable position. This keeps the farmer from having to sell $2.00/bu. cash corn, and instead they are able add an additional $1.00/bu. to their selling price by having the hedge in place.
Lab Activity – See “Long and Short Hedging Lab” below.
Futures Accounts – Margin
Futures Accounts – Margin
We have talked about what futures markets are and what they do. We have examined how short-hedgers and long-hedgers can use them to manage price risk. But, where does the gain or the loss come from on the futures transaction? The answer to that is pretty easy. However, fairly complicated! In essence, if you gain $0.50/bu. in the futures market, that means that someone else had to lose $0.50/bu. Futures gains and losses are a zero-sum game. Which means if you add up the winners and losers together you would get 0. But there is a way that this works so that it is efficient, and you never need to worry about the other side of your transaction failing to pay – “margin requirements”!
In order to trade futures, you first need to open a brokerage account through a Futures Broker:
Once you have an account opened up, you will be able to place trades with your broker. In order to place the trades, you will need to have enough money in your brokerage account to cover the maximum amount that you can lose in one day – the price limits. Price limits exist for two primary reasons; 1) as a circuit breaker for market (simply put if the price moves by too much, the amount of the limit, the market shuts down for the day allowing the market to determine if the prices should have moved that much) and 2) to allow time for brokers to collect enough margin money from account holders with positions in the market to cover the next days possible losses. In other words, buying and selling futures does not cost you anything up front (except the brokerage commission charged by your broker), you are required to cover any losses to your account as they happen. That is why limits are so important. The price limits are set by the exchanges and are subject to change, so I don’t like to tell you what they are. Instead here is the link to the current posting for the CME Group:
https://www.cmegroup.com/trading/price-limits.html#agricultural
If you click on the link, you will see that corn currently as of 5/19/2020 has a 25-cent limit. That means that the price can only increase or decrease by 25 cents from the closing price of the previous day. Since corn futures contracts are for 5000 bushels, the maximum amount that you can make or lose in one day is 5000 bushels X 25 cents/bushel = $1250/contract. In other words, to place a trade, either long or short, in the corn futures, you must have at least $1250/contract traded in your account at the time you enter the market.
Let’s assume you place $1500 into your brokerage account and then instruct your broker to sell 1 December 2020 Corn futures contract at $3.25/bu. The order fills and you are now short 1 December Corn futures contract at $3.25. If during the day the market goes up by 10 cents to $3.35, you will have $500 deducted from your brokerage account - $0.10/bu. * 5000 bushels = $500/contract. Your account balance will decrease to $1000, resulting in a “margin call” of $250. Essentially what will happen is that your broker will have to call you to collect $250 into your account. Why $250? Remember to trade corn you need to maintain at least a $1250 margin account (brokerage account) balance. When the clearinghouse (the arm of the exchange that handles the transfers of gains and losses between traders) debited your brokerage account for $500, you fell below the minimum threshold of $1250 or the limit per contract. By placing the $250 into your account, you are able to remain in your futures position. Now imagine the next day the market goes back up $0.10/bu. This time your margin account is credited $500. As a result, you now have $1750 in your margin account. Of which you could if you wanted to, withdraw $500 immediately, as long as you keep the required minimum of $1250 in your account.
This process will go on for as long as you hold a position in the market. Assume that on May, 20, 2020 you buy (go long) 1 December 2020 Corn futures contract at $3.30/bu., place the minimum margin into your account and hold that position for 10 days. The daily gain/loss and resulting daily balance would look like the following given the price movements indicated in the table:
Date | Price as of Close Today | Change from Previous Close | Change in Margin Account | Margin Call | Margin Account Balance |
5/20/20 | $3.35 | +$0.05 (from entry) | +$250 | - | $1500 |
5/21/20 | $3.45 | +$0.10 | +$500 | - | $2000 |
5/22/20 | $3.64 | +$0.20 | +$1000 | - | $3000 |
5/26/20 | $3.50 | -$0.15 | -$750 | - | $2250 |
5/27/20 | $3.30 | -$0.20 | -$1000 | - | $1250 |
5/28/20 | $3.10 | -$0.20 | -$1000 | $1000 | $1250 |
5/29/20 | $3.00 | -$0.10 | -$500 | $500 | $1250 |
6/1/20 | $3.05 | +$0.05 | +$250 | - | $1500 |
6/2/20 | $3.30 | +0.25 | +$1250 | - | $2750 |
6/3/20 | Sell at $3.40 | +0.10 | +$500 | - | $3250 |
At the end of 10 days when the long position is exited, the trader has an account balance of $3250. However, they initially placed $1250 of initial margin in the account and then made $1500 worth of margin calls. In total $2750 in their brokerage account is their own money. So take the balance of $3250 – the $2750 that they contributed to their account = $500 gain. $500/5000 bu. = $0.10 per bushel. That happens to be the difference between the price that the trader entered the futures in the long position of $3.30 and the price that they exited the futures of $3.40. This concept of margin and adjusting daily is known as “marked to the market” and it means that daily gains and losses are credited to the winner’s brokerage accounts and debited from the loser’s accounts for that day.
This is why in the video that I recommended you watch at the beginning of this unit talks about how there is no counter-party risk involved in trading futures contracts. Counter-party risk refers to the risk that when you sell grain to a buyer, there is a risk that you may NOT get paid. There have been several recent examples of this in North Dakota and all over the US. It does happen. It does NOT happen in futures markets, because of the margin requirements. I MUST have the amount that I could lose for the day posted to an account before I can stay in the market. If I receive a “margin call” and I do NOT put the money into my account to cover potential losses, I can have my position liquidated by my broker. That simply means the exit me from my trade so that I do not fail on my counter-party risk.
Lab Activity – See “Margin Account Lab” below.
Futures Contracts – Closing
Futures Contracts – Closing
The use of futures creates an ability for producers to become price makers, rather than often-cited price-taker mentality of many producers. To start with and for this course, we focus on the use of futures as a static tool. Meaning we put a hedge on and leave it until it is time to either buy or sell in the cash market depending on what type of a hedger we are. In practice though, hedging offers a lot of flexibility as well as the opportunity to add value to sales. It does carry additional risk, however. When we hedge remember we must be willing to say that we are OK with the current prices, and we are willing to give up some of the gain on the top. Futures do NOT make marketing grain easier, but the do offer a lot of tools to help the producers maximize their profitability.