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This chapter is from the book

The players

The two major classes of participants in the futures and options markets are the hedgers and the speculators.

Hedgers can account for from 20 to 40% of the volume and open interest in the major futures markets and up to half or more in some of the smaller contracts. Hedgers use exchange traded contracts to offset the risk of fluctuating prices when they buy or sell physical supplies of a commodity.

For example, a copper mining company might sell copper futures to lock in a sale price today for its future production. In this way, the company protects its profit margins and revenue stream should future copper prices drop. Should future copper prices rise, the company loses on its futures position; however, the value of its physical metal rises. The copper mine is a producer and is just trying to offset, or hedge, its price risk. A hedger can be a buyer or a seller.

A tube manufacturer, which buys copper as a raw material in the production of copper tube used for plumbing, might buy copper futures to lock in its copper cost for future purchase. If the price of copper rises, the manufacturer has a profit on its hedge, which can be used to offset the higher price of physical copper it needs to purchase in the marketplace. If copper prices fall, the manufacturer shows a loss on the futures side of the transaction, but it is able to buy the copper cheaper in the marketplace.

In either case, the copper mine or the tube manufacturer has the ability to hold its contracts into the delivery period. They then have the option to make or take copper delivery through the Exchange at an approved warehouse licensed to do business on the Exchange. This option is as important in theory as in practice because it is what allows physical commodity prices and the Exchange traded contracts to come together in price. If the price of the commodity is too high in relation to the futures price, then those people involved in the usage of a particular commodity buy the low-priced futures contracts and take delivery. Their buying, in effect, pushes futures prices up to meet the physical price. If the price of a futures contract is too high in relation to the actual commodity, then producers of that commodity sell the contract to make delivery, because the higher-priced futures (in relation to the physical) just might be their best sale. Their selling pushes the price of the futures down to the cash price. This entire process is known as convergence. This potential process of convergence is what makes the system work; however, in practice only, one to two percent of all commodity contracts end in delivery. Odds are that you, as a speculator, will never get involved in a delivery, and there's no need to. In fact, even the majority of hedgers do not use the markets to actually make or take delivery; they are using the futures as a pricing tool to help stabilize their revenues and their costs.

I have a client, a major manufacturing firm that publishes a biannual catalog with prices they honor during the catalog date. They use copper and zinc in their manufacturing process, and they know what their profit margin is based on today's price of copper and zinc. If they don't hedge and lock in the six-month price of copper today, and the price goes up during the time the catalog is distributed, their entire profit margin could be wiped out. The other side of the coin is that if copper prices fall and their published price remained based on the published higher prices of the raw materials, they could reap a windfall profit. However, they are not in the business of speculation; they are in the manufacturing business. They are more than willing to forego the chance of a windfall to be assured of a profit margin that allows them to keep the plant running and avoid layoffs.

A few times each year, I sit down with them and determine where to buy copper and zinc futures to lock in a price they can live with for the next six months. After they know this price, they can publish their catalog with peace of mind knowing that their profit margin is secure. If the price of copper rises, they will have to pay the higher price in the cash copper market; however, their futures contracts will rise in value as well, and the profits from the futures offset the higher price that must be paid in the physical market. If the price of copper falls, they will show a loss on their futures, but this will be offset by the lower price they will enjoy in the cash market when they buy their copper. In this particular case, this firm has documented an additional cost savings by using futures.

In the past, they used to lock in their price by buying six months worth of copper and zinc and storing the metal in large warehouses. At times, there were so many tons of metal that they had to rent space in warehouses they didn't own. Not only does this involve the rent and the cost of maintaining these warehouses (you have to pay forklift operators to move the goods), but think of the cost of money to finance thousands of tons of heavy metal. Now that they are assured of a future price, they maintain just two to four weeks worth of physical metal on location, and they have eliminated the need for many of these warehouses. The savings in interest alone is in the hundreds of thousands of dollars. This firm has never taken delivery on the futures. Actually, they do not even use the type of copper specified in the futures contract (the pure, or virgin, metal); they use scrap copper. However, because the price of scrap moves in the same direction as the price of the virgin metal, this is a good cross-hedge that works well in their risk-management program.

Many of the products hedged on a futures Exchange are actually cross-hedges. For example, jet fuel is similar to heating oil, which often is priced within a few cents different from each other. A major airline might use the heating oil contract to hedge its jet fuel requirements, and a trucking company might use the same contract to hedge its diesel fuel needs.

Basis risk

The definition of basis is the difference between the cash, or spot price, and the futures price. Every contract traded has what are termed specifications, which make the contracts fungible and standardized.

For example, let's look at the contract specifications for heating oil traded on the New York Mercantile Exchange:

Trading Unit

42,000 U.S. gallons (1,000 barrels).

Price Quotation

U.S. dollars and cents per gallon.

Trading Hours (All times are New York Time) Open outcry trading is conducted from 10:05 A.M. until 2:30 PM. After-hours futures trading is conducted via the Internet-based trading platform beginning at 3:15 P.M. on Mondays through Thursdays and concluding at 9:30 A.M. the following day. On Sundays, the session begins at 7:00 P.M.

Trading Months

Trading is conducted in 18 consecutive months, commencing with the next calendar month.

Minimum Price Fluctuation

$0.0001 (0.01¢) per gallon ($4.20 per contract).

Maximum Daily Price Fluctuation

$0.25 per gallon ($10,500 per contract) for all months. If any contract is traded, bid, or offered at the limit for five minutes, trading is halted for five minutes. When trading resumes, the limit is expanded by $0.25 per gallon in either direction. If another halt is triggered, the market will continue to be expanded by $0.25 per gallon in either direction after each successive five-minute trading halt. There will be no maximum price fluctuation limits during any one trading session.

Last Trading Day

Trading terminates at the close of business on the last business day of the month preceding the delivery month.

Settlement Type

Physical.

Delivery

F.O.B. seller's facility at New York harbor, ex-shore. All duties, entitlements, taxes, fees, and other charges have point paid. Requirements for seller's shore facility: capability to deliver into barges. Buyer may request delivery by truck, if available, at the seller's facility, and pays a surcharge for truck delivery. Delivery also may be completed by pipeline, tanker, book transfer, or inter-or intra-facility transfer. Delivery must be made in accordance with applicable federal, state, and local licensing and tax laws.

Delivery Period

Deliveries may be initiated only the day after the fifth business day and must be completed before the last business day of the delivery month.

Grade and Quality Specifications

These generally conform to industry standards for fungible No. 2 heating oil.

Inspection

The buyer may request an inspection for grade and quality or quantity for all deliveries, but shall require a quantity inspection for a barge, tanker, or inter-facility transfer. If the buyer does not request a quantity inspection, the seller may request such inspection. The buyer and seller share the cost of the quantity inspection equally. If the product meets grade and quality specifications, the buyer and seller share the cost of the quality inspection jointly. If the product fails inspection, the cost is borne by the seller.

This contract is standardized, in that all contracts created are the same. Contract specifications for all contracts traded on the Exchange are available from your commodity broker or the Exchange Web site. (A listing of the Exchanges is included in the Appendix of this book.) As a speculator, you really are not concerned with the delivery specifications, because you will not be involved in delivery—you'll be out long before it starts. What about the hedger? This particular contract calls for delivery of No. 2 heating oil in New York harbor. Of course, not all heating oil is used in the New York area, and prices in other cities will vary due to differences in transportation costs, storage costs, and local supply-and-demand considerations. A wave of Arctic air sweeping through Europe would no doubt raise the price of heating oil globally, but the price would rise faster in Rotterdam than in New York. These differentials are known as the basis. The basis can be stable and predictable at times. For example, if it costs 3¢ per gallon to transport heating oil from New York to Boston, the basis in Boston may predictably run at "plus 3¢ per gallon," all other factors remaining equal. However, if Boston is under a deep freeze and New York isn't, the basis might move up to "plus 4¢."

For the manufacturing firm I work with, the price of scrap copper can, at times, be at the price of the virgin metal (when there is a scrap shortage). Other times, it could be as much as 4 or 5¢ per pound under. The point here is that the hedger has what's called basis risk. Basis risk is almost always far less than the price risks involved without a hedge. A hedger who does not hedge is just like a speculator, because he is assuming the natural risks of the marketplace. Once again, I want to point out that most hedgers close out their futures positions long before their futures contracts expire, and the majority long before the delivery period even starts. Then they take or make delivery of the physical commodity they are involved in through normal channels by using their standard suppliers. Knowing that each contract is actually keyed into a specific actual grade of the underlying commodity keeps the value true to life. No matter what the underlying commodity is, each Exchange ultimately guarantees the purchase and sale, as well as the delivery grades for quality and quantity. This is why quotations from the Exchanges for most of the commodities traded are used as pricing standards by companies and individuals around the world.

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