Commodity Futures
Although this course focuses on single-stock futures, we will expand your futures education by using a quick course in commodities. This will aid in your understanding partly because it's easier to understand why someone would want to engage in a futures contract on a commodity rather than a stock.
For instance, it's easier to understand why a farmer might want to lock in his purchase price of cows in three months rather than it is to understand why you would want to lock in your price of a stock other than to defer the cost. Once you get the idea of how futures have been used for commodities, it will be easier to adapt that reasoning over to stocks. Another reason is that, as you trade single-stock futures, you may find yourself interested in commodities. Once you see the power of futures contracts, you will find many opportunities in futures as world events unfold that simply are not possible with stocks or mutual funds. Wars in the Middle East, wildfires in California, mad cow disease, and droughts in Florida all will present new investment opportunities. However, there are quirks in the way some commodities are quoted, and we want you to at least be comfortable enough to find the information and read the quotes.
So for starters, let's assume you are a farmer and will have 80,000 pounds of live cattle to sell in three months. The price for live cattle is very favorable and you'd like to sell today, but you cannot since the cows will not be ready for delivery until that time. What can you do? By now you should know the answer. You need an asset that gains in value if prices should fall, so you need to sell a live cattle futures contract. The short contract acts as a hedge to falling prices. We also discussed another method of how to figure out what kind of hedge you need. Because you are the seller of live cattle in the future, you would be the seller of the contract today. As long as you figured out that you'd need to be short a live cattle contract, you're getting the idea!
Using The Web
The live cattle contracts are traded on the CME (Chicago Mercantile Exchange). Go to their Web site at the following link:
Once you're there, click on:
1) Move the mouse over "Products" link at the top
2) Select "Commodity Products" link on the left
3) Under the heading "Beef" click on the "Live Cattle" link
4) Click the "Contract Specifications" link
Using the Web
Go back to the CME's homepage and get a current quote on the live cattle contract:
How many pounds of live cattle does one contract control?
Understanding the Contract
As we said earlier, there are many different sizes of commodity futures contracts. It all depends on the commodity, whereas single-stock futures contracts are standardized at 100 shares each. If you did the above exercise correctly, you found that one live cattle futures contract controls 40,000 pounds of live cattle. The quotes are in cents per pound, so a quote of 63.85 means you are contracting to pay 63.85 cents per pound for 40,000 pounds of beef for a total contract price of 0.6385 * 40,000 = $25,540.
Using The Web
Go back to the CME's homepage and get a current quote on the live cattle contract:
- Look for the "Quick Links" on the right side of the page and click on "10 minute Intraday Quotes"
- Go to the main page. Click on "Delayed Quotes" link near the top on the left. Click on "Agricultural Commodity" link near the top in the middle of the page. Scroll down until you see "Live Cattle" and click on the "Pit Traded" link under the "10-Minute Futures" heading.
What is the last price of the live cattle contract now? What is the total contract value at that price?
Now find the initial margin levels:
- Click on "Clearing Services" at the top of the page
- Click on "Risk Management/SPAN"
- Click on "Performance Bond Requirements" on the left hand side
- look for "Agricultural Futures" under that. Then click the "Outright" link to the right of that.
Under "Live Cattle," you want to find the "Spec" row, which stands for speculation. To the right, you will see the initial margin and maintenance margin levels. At the time of this writing, these levels are $810 and $600 respectively. These numbers are usually updated about every month or so to keep up with changing prices and volatility. Keep in mind that these are the exchange minimums, and that brokerage firms are allowed to make the requirements stricter. You can see there is tremendous leverage with these live cattle contracts as one could control over $25,000 worth of live cattle for as little as $810 initial margin. That's only a little more than 3% down, which is substantially less than the 20% that will likely be required for single-stock futures
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Entering the Contract
If you have 80,000 pounds of live cattle to sell and each futures contract controls 40,000 pounds, you will need to sell 2 contracts, which will then total 80,000 pounds and provide full price protection. If you don't wish to sell the cattle for three months, you would need to sell a futures contract that expires in three months. For instance, if it is now January, you would sell an April live cattle contract. It is possible that the contract you need does not exist at the time. If that's the case, you can always sell a longer-term contract and close out the contract in the open market. This is getting a little ahead of the course and we will certainly talk about it later. I just want you to understand that it is possible to not find the contract you need, but there are also ways to fix it.
If your broker charges the minimum initial margin ($810 in this example), you will need to deposit twice that since you are selling two contracts, or $1,620. The execution will take seconds and you will be short 2 live cattle futures contracts. That's all there is to it!
What Price Will I Get for the Contract?
We said in the beginning that futures are not options and that you do not get to choose your purchase or selling price like you do with options, which are called strike prices. The price of the futures contract is determined through supply and demand, and it fluctuates constantly just like shares of stock. If you enter your order "at market," you will receive the best price available once your order hits the exchange floor. There are many ways to enter an order just as there are with stocks. We will talk about those later on in the course.
But for now, let's assume you enter a market order and are filled at a price of 63.85. Once again, this just means that you are obligated to sell your 80,000 pounds of live cattle for 63.85 cents per pound at the expiration date in April (which happens to be the last business day of the month for live cattle futures). If you do, you will receive .6385 * 80,000 = $51,080 for your herd. This is, in fact, the selling price you are trying to protect (hedge). If you could sell your cows today, you'd receive $51,080; however, you are not able to so are exposed to the risk of falling prices, which is the risk all sellers are exposed to when they must defer a sale. Keep the price of $51,080 in the back of your mind as we will refer back to it shortly.
How Will the Contract Protect My Price?
Think back to the earlier courses during the first lessons when we talked about the digital camera "futures contract" and the Lexus car dealer with the Japanese yen futures contracts. If you understood those examples, this example is the same idea but in just another form -- cows instead of yen.
It never hurts to keep practicing with examples, so let's go through this one and see how it would hedge your selling price.
Suppose that live cattle prices have fallen and are now going for 57 cents per pound at the expiration. You have two choices to close the position; either one will result in the same profit or loss to you.
Example #1
First, let's assume you just close out the contract in the open market, which is the way about 95% of all futures contracts are handled. Because you sold the contract, you must buy it back in order to reverse your obligations. What price will you pay? Well, think about what a futures contract is. It guarantees the delivery of an asset in the future. If that future date is today (in other words, the contract is almost expired) shouldn't the futures price be the same as the current price? That is, in fact, what would happen -- you would pay the current market price of 57 cents to close out the contract. We'll give a more formal reason why the futures price will equal the current price at expiration in a later course.
You sold two futures contracts at 63.85 and purchased them back at 57, which is a gain of 6.85 cents per pound. Remember, short futures contracts gain value as the underlying asset falls. In effect, you sold high and bought low, which is just the reverse of the normal "buy low-sell high" profit equation.
This translates to a gain of $.0685 * 80,000 pounds = $5,480. You therefore have a nice profit of $5,480 on your two futures contracts. However, now you must get rid of your cows at the market price of 57 cents per pound and receive 0.57 * 80,000 = $45,600 instead of your anticipated $51,080, which is a shortfall of $5,480 -- exactly the amount of the gain on your futures contract. The $45,600 you receive from the cattle combined with the futures profit of $5,480 = $51,080, which is exactly the price you wanted to ensure three months ago that you'd receive today.
Here are the calculations:
| Today: | Price | | Total contract amount | | Total contract value |
| Sell 2 live cattle futures | 63.85 cents | * | 80,000 pounds | = | $51,080 |
| | | | | | |
| 3 months later: | | | | | |
| Buy 2 live cattle futures | 57 cents | * | 80,000 pounds | = | $45,600 |
| | | | | | |
| Price difference | 6.85 cents | * | 80,000 pounds | = | $5,480 |
Now it should be apparent what we meant in the earlier courses when we said that hedges are not designed make profits but rather to offset losses. The apparent profit in your futures contract was just a hedge against the loss you had to take on the underlying asset (live cattle) in the open market.
Example #2
Now let's assume that prices rise to 70 cents at expiration. If you closed out your contract, you must buy it back at the current price of 70 for a total purchase price of 0.70 * 80,000 = $56,000. You sold for $51,080 and bought back for $56,000, which is a loss of $4,920 on the futures contract. However, you can now sell your cows in the open market at the more favorable price of 70 cents per pound and receive $56,000. Once you incorporate your loss on the futures contract with your sale price of the cows, your net proceeds are $56,000 - $4,920 = $51,080 and is exactly the price you were trying to lock into three months ago. Notice how the futures contract, whether prices rise or fall, ensures that your selling price is $51,080 at expiration.
Here are the calculations:
| Today: | Price | | Total contract amount | | Total contract value |
| Sell 2 live cattle futures | 63.85 cents | * | 80,000 pounds | = | $51,080 |
| | | | | | |
| 3 months later: | | | | | |
| Buy 2 live cattle futures | 70 cents | * | 80,000 pounds | = | $56,000 |
| | | | | | |
| Price difference | -6.15 cents | * | 80,000 pounds | = | ($4,920) |
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Watch Out for Quote Aberrations with Commodities
Single-stock futures are always quoted in dollars per share for 100 shares of stock. However, there are many aberrations with commodity quotes -- especially in the grains -- that you need to be aware of.
For example, let's get a quote on the corn futures contract at the Chicago Board of Trade (CBOT) by entering the following steps:
Using the Web
- Go to http://www.cbot.com/
- Click on "Market Data" at the top
- Click on "Delayed Quotes"
- On the left side click on "Products"
- In the middle of the page click on "Corn"
One corn futures contract controls 5,000 bushels of corn. If you look at the quotes in the table, what do you suppose is the total contract value? At the time of this writing, the current month was quoting 2284. One may certainly be led to believe that this quote means that one contract would cost 2284 cents or $22.84 * 5,000 = $114,200. The reality is that the grains are quoted in cents and quarter cents per bushel so 2284 really means 228 cents + 4/8 cents. The last digit in the grains represents the 1/4-cents. What makes it more confusing is that it is really measured in eighths! This is because the grains used to be quoted in eights so if the last digit is a 2, that means 2/8 or 1/4-cent. If the last digit is a 4, then that represents 4/8 or half a cent, and so on. If you look at the grain quotes, you will notice that the last digit is always a 0, 2, 4, or 6, which measure the 1/4-cent minimum increments for these contracts.
The point of all this is that commodity quotes are not standardized and can be confusing at first. If you decide to trade commodities at some time, be sure to have your broker explain the quotes or other aspect of the contract if you are unsure. You don't want to learn the hard way.
Aside from that, a futures contract is a futures contract and the idea behind them is all the same. Only the underlying assets differ. If you understood the examples in the beginning of the course as well as the commodity example in this course, you will have no trouble understanding the power that single-stock futures will bring to your portfolio once we start talking about strategies.
But first we're going to turn our attention to a couple of academic topics. In the next course, we will find out why the futures price must converge to the spot price. In the following course, we will show how futures contracts arrive at a fair price.
 | Key Points |
- The idea behind futures contracts is all the same whether we're talking about commodities or single-stock futures. They can be used to speculate on price movement or used to conservatively hedge.
- Be careful when quoting commodities, as the quotes are not standardized as to contract size or dollar representation.
Using the Web
If you wish to see more contract specifications for single-stock futures, visit this site at onechicago.com.
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