Commodity Derivatives

In the last 25 years, derivatives have become increasingly important in the world of trading. Futures and Options are now traded actively on many exchanges.

A derivative can be defined as a financial instrument whose value depends upon (or derives from) the value of other basic underlying variables. Very often, the variables underlying derivatives are the prices of traded assets. For example, a commodity option is a derivative whose value is dependent on the price of a stock. The underlying variable can be anything. Active trading is happening in credit derivatives, electricity derivatives, weather derivatives, insurance derivatives etc. many new types of interest rate, foreign exchange and equity derivative products have been created. A commodity derivatives market (or exchange) is, in simple terms, nothing more or less than a public market place where commodities are contracted for purchase or sale at an agreed price for delivery at a specified date.

Derivatives are not only used as trading products, but also for hedging the position of the producer or trader against unexpected market conditions. Hedging is defined as taking simultaneous but equal and offsetting positions on the cash and futures markets. The basic idea behind hedging is to hold opposing positions in the two markets at the same time. Each market position offers protection from an adverse price change in the other market. The cash market position (that is, for example, holding or growing grain) is a necessary part of the producer. This cash market position puts the producer at risk from a decline in grain prices. Taking an offsetting position in the futures market is a ‘hedge’ against the potential for a harmful move in the cash market price. At the same time, the cash market position (holding or growing the grain) can protect him from losses on the futures market.

Futures and Options are the two major derivative mechanisms.

Commodity Futures

A futures contract is a standardized contract that is traded on a futures market exchange. The contract specifies the commodity, place of delivery, quality, and time of delivery. Quality if the commodity will not be stated in the contracts listed, but these specifications are an explicit part of each contract. Price is the only essential component of the futures contract that is not pre-specified. Price is determined by the interaction of buyers and sellers in a location (called the trading pit) designated by the exchange. The exchange establishes the time periods when trading takes place, develops and enforces other rules associated with trading, and provides additional services needed by traders. The actual buying and selling that occurs in the trading pit is done by individuals that have purchased the right to trade (called a seat) on the exchange. Thus, the general public buys or sells futures contracts through a broker who has access to a seat on the exchange.

Although the procedures involved in actually trading futures contracts may appear complex, knowledge of only a few basic marketing concepts is needed to understand the idea of hedging. Through the broker, it is possible to sell a futures contract (take a short position) today with the understanding that you must offset the short position (that is, buy the contract) at a later date. The idea of selling something (going short) before you buy something may seem strange, especially if you have traditionally sold in cash markets. It is important to keep in mind that the futures contract is a formal agreement, and you can agree to sell something in a future time period even when you don‘t have something to sell now. If prices decline between the time you sell and buy the futures contract, you then buy the contract at a price below your sale price. You receive the gain associated with this ―sell high – buy low‖ transaction. If you initially sell a futures contract (a short position) and the price increases, you must buy at the higher price. You suffer the loss associated with this ―sell low – buy high‖ transaction.

As a futures trader, it is also possible to buy a futures contract (take a long position) with the understanding that you must offset with a sell at a later date. Impacts of price changes from this long position are just the opposite of those discussed for the short (sell) position above. That is, if you take a long position and price declines, you incur a loss on the ―buy high – sell low‖ transaction. If you take a long position and price increases, you gain from the ―buy low – sell high‖ transaction. Buying or selling futures contracts requires the service of a broker with access to the exchange where futures contracts are traded. Your broker conducts trades on your behalf per your instructions. You pay a fee to the broker (a commission) for executing an order to buy or sell a futures contract. Like payment for any service, commissions vary by broker. Commissions are normally quoted for entering and closing a futures position (called a round turn).

Since all traders with a futures position can potentially suffer losses, all traders must put up a deposit (a margin) to ensure all losses will be paid. A margin is the money deposited by both the buyer and seller to guarantee performance under the terms of the futures contract. Minimum margins are established by each commodity exchange, but individual brokers may have higher margin requirements. This initial margin is typically a small portion of the total value of the contract, and may not cover a trader‘s total loss over time. Therefore, a margin call is a request for additional money the futures trader must deposit if adverse price moves significantly devalue the initial margin deposit. If the market moves against your position by an amount such that your initial margin may not cover additional losses (called the maintenance margin), the broker asks for more money. That is, you receive a margin call from your broker and the additional money is required to keep your futures position.

Since the idea of hedging is for losses on one market to be offset by gains in the other market, price changes in the two markets must be related. This price relationship between the cash and futures market is measured by a concept called basis. Basis is the difference between the price at cash market and the futures price (that is, cash price minus the futures price).

This relationship (or basis) is a particularly important concept in effective hedging. The whole purpose behind hedging is for adverse price moves in the cash market to be offset by favorable price moves in the futures market. If the two markets aren‘t related in some way, hedging doesn‘t work. Thus, measuring and understanding basis is the key to successful hedging.

Basis is normally calculated as your local cash price minus the nearby futures price. Basis is often quoted as over (a positive basis) or under (a negative basis). ‘Over’ or ‘under’ refers to the cash price being above or below the futures price, respectively. Basis relationships change over time. A weakening basis occurs when the cash price declines relative to the futures price. A strengthening basis occurs when the cash price increases relative to the futures price.

Commodity Options

A commodity option is a two-party agreement that gives the buyer (or holder) the right, but not the obligation, to take a futures position. This potential position can be either a short or a long position in a designated futures contract (called the underlying futures contract). The futures position will be provided at a specified price (called the strike price or exercise price), and the right exists until a pre-established date (called the expiration date). Although expiration dates vary, most options on grain futures expire during the last week of the month before the contract month of the underlying futures contract.

An option is purchased from an option seller (called the writer or grantor). The writer of an option has the obligation to provide the option holder with the futures position at the agreed-upon strike price. As the buyer, you purchase the option at the going market price (called the premium). If cash grain prices move unfavorably, you may use the option to obtain the protection associated with a futures position. The option seller is obligated to provide you with the futures position at the strike price. However, you don‘t want the protection associated with a futures position if cash grain prices move favorably. As the holder of the option, you are not obligated to take a futures position. Thus, options are similar to purchasing insurance. You pay the premium, but you may or may not need the protection of the underlying futures position. Two types of options are available for each underlying futures contract. The purchase of a put option gives the holder the right to a short futures position at the strike price. The seller of the put must provide the holder with the specified short futures position. The purchase of a call option gives the holder the right to a long futures position at the strike price. In this case, the seller of the call option must provide you as the holder with the specified long futures position.

Purchasing a put option (the right to sell a futures position) protects you as the holder of the put against falling cash prices. If prices fall, you have the right to a short futures position at the higher strike price. A short futures position at a high price means you can offset with a buy at the current lower market price and receive the gain. Purchasing a call option (the right to buy a futures position) protects you as the holder of the call against rising prices. If prices rise, you have the right to a long futures position at the lower strike price. A long futures position at a low price means you can offset with a sell at the current higher market price and receive the gain. A call option can also be used as a fairly low risk strategy to participate in market price gains after your physical commodity has been sold.

There are technical terms used in Option contracts. The common words used in an Option contract are explained below.

  1. Strike Price: The “specified price” in the option is referred to as the exercise price or strike price. This is the price at which the underlying commodity can be exchanged and is fixed for any given option, put or call. There are several options with different strike prices traded during any period of time. As a general rule, the more volatile the price is for the underlying commodity, the greater the number of options at different strike prices that will be available for trade. If the price of the underlying commodity changes over time, then additional strike prices may be traded.
  2. Underlying Commodity: The underlying commodity for the commodity option is not the commodity itself, but rather a futures contract for that commodity. For example, a June chilli option will actually be an option for a June delivery chilli futures contract. In this sense, the options are on futures and not on the physical commodity.
  3. Buyers and Sellers: In the option market, as in every other market, every transaction requires both a buyer and a seller. The buyer of an option is referred to as an option holder. Holders of options may be either seekers of price insurance or speculators. The seller of an option may also be either a speculator or one who desires partial price protection. Whether one chooses to buy (hold) or sell (write) an option depends primarily upon his/her objectives. The market will contain many insurers and price speculators, each providing a service to the other.
  4. Expiration: Options on agricultural commodities have futures contracts as the underlying commodity. Futures contracts have a definite predetermined maturity date during the delivery month. So too, options will have a date at which they mature and expire. For example, a Rs.5,100 June chilli Option is an Option to buy or sell one June chilli futures contract at Rs.5,100. The option can be exercised by the holder on any business day until mid-May at which time the option expires. Trading in most options will not be conducted during the futures contract delivery month. Upon expiration, the Option becomes worthless.
  5. Option Premiums: The option (put or call) writer or grantor is willing to incur an obligation in return for some compensation. The writer of an option is an option seller. The compensation is called the option premium. Using the insurance analogy, a premium is paid on an insurance policy to gain the coverage it provides and an option premium is paid to gain the right granted in the option. The premium is determined by public outcry and acceptance in an exchange trading pit, and like all commodity prices, can be expected to change daily.