CME Commodity Trading Manual - KIS FUTURES

1 CME Commodity Trading ManualThis book was originally designed as a guide for teachers of highschool agricultural education programs. It contained supplementalmaterials and study pages, and was one of the first organizedcommodity marketing courses for high school original course was funded by Chicago Mercantile Exchange(CME) in conjunction with the National FFA Foundation and theStewart-Peterson Advisory Group. Several individuals contributed tothe project, including high school instructors to whom CME is grateful. The success of the course in the schools has prompted CME to redesignthe book as a textbook, revise and update it once again, and make itavailable to anyone who wishes to gain a comprehensive introductionto Commodity the OneMARKETING BASICS .. 1An overview of the FUTURES market and its development; marketing alternativesChapter TwoFUTURES MARKETS.

2 13 How producers use the FUTURES market for the sale or purchase of commoditiesChapter ThreeTHE BROKERAGE ACCOUNT .. 27 Practical information regarding choosing a broker and placing ordersChapter FourSUPPLY AND DEMAND .. 37 Factors that affect supply and demand and the impact on projecting prices for commoditiesChapter FiveANALYTICAL TOOLS .. 49 Introduction to technical analysis and charting Chapter SixOPTIONS TERMS .. 63 Introduction to options and how to use them to hedge a sale or purchaseChapter SevenOPTIONS STRATEGIES .. 77 Selling and purchasing strategiesChapter EightMARKETING MATH .. 91 Answer Keys for Chapter Exercises.. 105 Glossary.. 107 Table of ContentsChapter One | Marketing Basics1 Marketing Choices Producers have four marketing you are involved in the production of agricultural commodities, you can price your commoditiesusing one or more combinations of these four alternatives: Cash sales Forward contracts FUTURES contracts Options on FUTURES contracts 1.

3 With cash salesyou deliver your crop or livestock to the cash markets (such as the grainelevator or meat packer) and receive the price for the day. You get cash right away, and thetransaction is easy to complete. But using this alternative, you have only one chance to take what you can get. This is actually one of the riskiest marketing alternatives forward contractis negotiated now for delivery later. It is easy to understand. You enter a contract with the buyer who agrees to buy a specified quantity and quality of the commodityat a specified price at the time of delivery. The price is locked in, and you are protected if pricesfall. However, you cannot take advantage of price increases, and you must deliver the specifiedamount, even if you have a crop failure. Both parties have some risk that the other will nothonor the 1 Marketing BasicsChapter One Objectives To understand the evolution of the Commodity marketplace To understand the role Commodity exchanges play in the market To learn the four marketing alternatives and to be able to describe their advantages and disadvantages To introduce the basic vocabulary of the commodities Trading marketplace To learn about cash sales and forward contractsCommodity Marketing23.

4 A FUTURES contractis an agreement to buy or sell a Commodity at a date in the future . You buyor sell through a brokerage firm that transacts the trade for you. Once you are set up with afirm, it is as easy as a phone call to make a trade. You must deposit a performance bond (asmall percentage of the contract value) with the brokerage firm to guarantee any loss you mayincur on the FUTURES contract. If the value of the contract goes against your position, you willbe asked to deposit more money. You also pay a broker a commission for every contract traded.(You will learn more about FUTURES later in the chapter.)Hedgingis selling or buying a FUTURES contract as a temporary substitute for selling or buying thecommodity at a later date. For example, if you have a Commodity to sell at a later date, you can sell afutures contract now.

5 If prices fall, you sell your actual Commodity at a lower cash price, but realize again in the FUTURES market by buying a FUTURES contract at a lower price than you sold. If prices rise,your higher price in the cash market covers the loss when you buy a FUTURES contract at a higher pricethan you sold. This may be considered a pure hedge, or a replacement hedge. It minimizes your riskand often earns you more than the forward contract Options on FUTURES contractsare traded at FUTURES exchanges too. (You will learn more aboutoptions in Chapter Six.) An option is the right, but not the obligation, to buy or sell a futurescontract at a specified price. You pay a premium when you buy an option, and you pay acommission to the example, if you buy a put option and prices rise, you can let the option expire and sell inthe cash markets at a higher price.

6 If prices fall, you can protect yourself against the low cashprice by: Offsetting the option (sell the same type of option). Exercising the option (exchange the option for the underlying FUTURES contract).Forwardcontract A private, cash market agreement between a buyer and seller for the future delivery of acommodity at an agreed price. In contrast to FUTURES contracts, forward contracts are notstandardized and not transferable. Futurescontract An obligation to deliver or to receive a specified quantity and grade of a commodityduring a designated month at the designated price. Each FUTURES contract is standardizedby the exchange and specifies Commodity , quality, quantity, delivery date and settlement. Hedging 1 - Taking a position in a FUTURES market opposite to a position held in the cash marketto minimize the risk of financial loss from an adverse price change.

7 2 - A purchase or saleof FUTURES as a temporary substitute for a cash transaction which will occur One | Marketing Basics3 Cash SalesCash sales involve risk for the a producer of corn, wheat, soybeans, cattle, hogs or dairy products, you will eventually sell yourcommodity in the cash markets. You can sell directly in your local markets or negotiate a forwardcontract for sale at a later date. Even if you sell FUTURES contracts or buy options to sell FUTURES , you willclose out your position and sell your Commodity in the cash markets. Very few FUTURES contracts areactually you are selling grain or livestock on a cash basis, the terms are negotiated when you bring in thegrain or livestock. The price is established then and there, and you make immediate delivery andreceive payment.

8 This type of sale occurs at elevators, terminals, packing houses and auction The right, but not the obligation, to sell or buy the underlying (in this case, a futurescontract) at a specified price on or before a certain expiration date. There are twotypes of options: call options and put options. Each offers an opportunity to takeadvantage of FUTURES price moves without actually having a FUTURES AlternativeCash sales Forward contract FUTURES contract Options contract Advantages Easy to transact Immediate payment No set quantity Easy to understand Flexible quantity Locked-in price Minimize risk Easy to enter/exit Minimize risk Often better prices than forward contracts Price protection Minimize risk Benefit if prices rise Easy to enter/exit Disadvantages Maximize risk No price protection Less flexible Must deliver in full Opportunity loss if prices rise Opportunity loss if prices rise Commission cost Performance bond calls Set quantities Premium cost Set quantities Commission cost Commodity Marketing4 You can choose when to sell

9 Grains in the cash market. You can sell at harvest or store the grain untillater when you expect prices to be better. Because of storage costs, there is risk involved in waiting forprices to rise. For example, if it costs you $ per month to store soybeans, then the price fourmonths from now would have to be more than $ ($ x 4 months) better than harvestprices for you to gain any advantage over selling at can also make a cash sale with a deferred pricing deliver the Commodity andagree with the buyer to price it at a later time. For example, you may deliver corn in October and priceit at any time between then and March. In this way, you transfer the physical risk of having the cornand the storage cost, and you may be able to get a higher price for the corn. Of course, there is theadded risk of the elevator s financial ContractsYou can negotiate a forward contract with your local merchant for future delivery of your crop orlivestock.

10 You and the buyer agree on quantity, quality, delivery time, location and price. This shouldbe a written you enter into this contract, you eliminate the risk of falling , if prices go higher at delivery time, you ll still receive the negotiated you make delivery, it will be inspected before payment is made. There may be a premium ordiscount in price if quality or quantity Markets Cash Sales/Deferred Pricing Forward Pricing/Basis ContractA basis contract is another method of forward contracting. In this case, you lock in a basis relating to aspecified FUTURES contract. When you deliver, the price you receive is the current price of the specifiedfutures contract adjusted by the basis you agreed upon. For example, if a basis of $ under wasspecified in the contract and the FUTURES price is $ on the delivery date, then the cash price youreceive is $ ($ + -$ = $ ).