Making sense out of crop marketing terms, like hedgers versus speculators, puts versus calls, derivative marketing tools and option premiums, can leave you scratching your head. But not understanding these terms can also complicate how you might make your next move in the markets. In this post, we'll break down some of the most common crop marketing terms and the ABC's of futures and options.
A brief background on “hedgers” versus "speculators:" Hedgers take positions in futures to reduce existing risk, while speculators willingly take on new risk for the chance to profit from correctly anticipating changes in futures prices. Both hedgers and speculators are needed to generate sufficient trading volume and market liquidity on any given day for easy entry and exit of trades, whether long or short.
Some of the most common terminology related to futures and options includes:
Futures contract – a standardized agreement between a buyer and a seller to exchange an amount and grade of a commodity at a specific price and future date. Those who buy futures in anticipation of rising prices are said to be “long”. Those who sell futures in anticipation of lower prices are said to be “short.”
Producers “hedge” their price risk on a growing crop by selling a futures contract at the current price. They’ve essentially eliminated downside price risk in futures, while remaining open to basis risk.
If grain prices fall, profits in their hedged futures position will offset the declining value of their actual crop, while if prices rise, losses on their hedged position will be largely offset by rising prices for their actual crop. It may not be a perfect hedge, with penny-for-penny offsets, however. Changes in basis can still enhance or erode the net price change between futures and local cash bids.
Others may eliminate price risk by buying a futures contract. Once they cover their needs with a long position in futures, if prices rise, profits in the futures position will help offset rising prices for inventory they’ve not yet purchased in the cash market; however, if prices decline, losses on their futures hedge will be offset by declining prices for inventory not yet purchased.
Hedger – As noted earlier, a “hedger” is someone who reduces price risk by taking out a futures position just opposite his/her position in the underlying commodity. A soybean grower, for example, is automatically long in that he/she benefits if prices rise for a growing or stored crop and is harmed if prices decline. By selling a futures contract, a producer is “hedged” on that long position in the cash market. Going forward, if prices rise, the rising value of his growing or stored beans will cover losses on the futures while if prices decline, profits on his futures position will cover declining value of the beans in the field or bin.
Speculator – Someone who willingly accepts or takes on price risk to profit from price change in their favor. In rawest terms, a speculator is anybody who goes long (buys) something solely to benefit from rising prices but suffers loss if prices decline instead. The term also applies to someone who goes short (sells) something he/she does not own and thus profits if prices decline and suffers loss if prices rise.
In this sense, even farmers who never trade futures at all are speculators by growing or storing unpriced grain. A speculator can also be anybody who requires a certain commodity in their business and benefits from declining cost but is hurt by rising costs. For example, a cattle feeder is speculating on feed costs until he locks in the cost of feed required.
Futures “carry” – the premium structure of deferred contracts over the nearby or “spot” contract. By definition, futures carry is related to the cost of storing grain so as to spread sales over a marketing year. But if you have grain in on-farm storage, it’s a different story. You have the interest cost and possibly some additional shrink adding up to perhaps 3 cents per month. A note on “carry:” In a true bull market, rallies are led by nearby contracts, often eliminating carry. It’s the market’s way of saying it wants corn now, not later. When nearby contracts are higher than deferred contracts, with no carry at all, the market is said to be “inverted” from its normal structure.
Margin requirements – Since futures exchanges guarantee that no one will ever be denied rightful futures gains, they require both an initial margin requirement and maintenance margin thereafter when you buy or sell futures.
That variation stems from variation in the “face value” of the contract. For example, a 5,000-bu. futures contract in corn at $3.80 has a face value of $19,000. A 5,000-bu. contract of wheat at $5.10 has a face value of $25,500 and a 5,000-bu. contract of soybeans at $10.25 has a face value of $51,250. Daily trading ranges often vary accordingly, thus the different margin requirements.
Differing face value isn’t the only factor in different margin requirements among commodities. Exchanges calculate futures margin rates using a program called SPAN. This program measures many variables to arrive at a final number for initial and maintenance margin in each futures market. The exchanges adjust their margin requirements based on market conditions. The most critical variable is the volatility.
In highly volatile markets, margin requirements will be raised. In dull, quiet markets, margin requirements may be lowered. In addition, margin requirements can be raised further by various brokerage firms based on their perception of 1) current risk in any given market or 2) risk-bearing ability on a client-by-client basis. This is often because the broker is held liable by the exchanges for losses their client cannot cover. They will set margin at whatever levels needed to minimize that exposure.
Maintenance margins are typically set at half those initial margins. Keep in mind that both initial margin and maintenance margin varies significantly by commodity, reflecting variation in the face value of a contract, variation in daily trading limits, and the recent volatility of trade in that particular commodity. For example, in wild weather markets where soybeans might be trading regularly in 20-30 cent swings, margin requirements may be raised by the exchange.
Futures options – Purchasers of options on underlying futures markets receive the right, but not the obligation, to accept a long or short futures position at a specific “strike price” sometime in the future for a fixed price called the “premium.” That premium is the most you may lose. There are no initial margins or risk of margin calls on purchased options, just the premium quoted plus the broker fee.
If it never becomes profitable for you to exercise your option, it simply expires. But if it does become profitable for you to “exercise” your option at expiration, you are assigned the futures position at that strike price, even if the underlying futures price has yet to trade at that price. (A party who sold an option at that same strike price is simultaneously assigned the opposite position in futures, already at a loss and still exposed to further margin calls.)
There are two types of options: Puts and Calls. A “put” option is the right, but not the obligation, to a short futures position at a specific strike price at a fixed premium. A “call” is the right, but not the obligation to a long futures position at a specific strike price in exchange for a fixed premium. Again, since there is no obligation to exercise an option that would entail a loss, you can just let it expire worthless, costing you only what you paid for it. Exercising is truly “optional,” hence the term.
Options on futures may also be sold at the current premium for the offered strike price by those who expect it to expire worthless to the buyer. This is also called writing an option. Option sellers, however, are exposed to margin calls, just as if you had an outright position in futures. This is to insure if it becomes profitable for the buyer to exercise the option you sold, there’s enough margin (supplied by you) to cover his gain. Otherwise, the Exchanges would have to cover it.
The premiums quoted for the various strike prices of puts and calls are typically determined by three primary drivers:
- “Intrinsic value.” This is the difference between the strike price and the current quote for the underlying futures price.
- “Time Value.” This is the amount of time between the present and expiration of the option. The longer that time, the higher the premium because there is higher risk to the seller that market conditions may change between, say, March and November than between March and May. In exchange for taking that greater risk, option sellers will need a higher time value component, over and above any intrinsic value.
- “Current Market Volatility.” This is a third element factored into the cost of options, whether puts or calls. The higher the recent volatility, the higher the risk associated with selling options and the higher the extra premium sellers will ask.
Secondary drivers of option premiums worth mentioning are:
1) The current trend in the market
2) The current market psychology as to how much longer and further that trend will persist.
There are also derivative marketing tools that derive their value from underlying futures contracts, but do not require you as the farmer to take a position in futures, or even have a trading account, for that matter. The counter-parties are the ones who have futures exposure.
Here are some common ones:
- The Hedge-to-Arrive (HTA) contract. This allows you to lock in a futures price (effectively “hedge”) with his local merchant, but without exposure to initial margin requirements or margin calls.
- Minimum price contract. This guarantees you a minimum price for a fixed fee with opportunity to profit if prices rise. These typically involve the purchase of put options by the merchant at the minimum price locked in for the producer, often covered by the fee paid by the producer. And just like the HTA, another benefit to the merchant is guaranteed delivery and handling volume.
- Accumulator contract. This allows you to lock in sales of a specific total amount of grain at an initial price that’s often above current futures, spread over as much as the entire growing season. The initial price is paid for each weekly “batch” priced so long as the futures price falls between that minimum price and a “knock-out” price at which sales halt.