Trading The Soft Commodity Markets

By Hank King AAA

The soft markets are made up of cocoa, coffee, cotton, orange juice and sugar, some of the oldest commodities still around today. You can trace their roots in commerce back over thousands of years. It is important to note that trading in this market involves substantial risks and is not suitable for everyone, and only risk capital should be used. In this article, we'll show you how to use this "sweet" market properly, because any investor could potentially lose more than originally invested.

What are soft futures contracts?
A soft futures contract is a legally binding agreement for the delivery of cocoa, coffee, cotton, frozen concentrated orange juice and sugar in the future at an agreed upon price. The contracts are standardized by the ICE Futures U.S., previously known as New York Board of Trade (NYBOT), and regulated by the Commodity Futures Trading Commission, as to quantity, quality, time and place of delivery. Only the price is variable. (To read more about futures, see Futures Fundamentals, Interpreting Volume For The Futures Market and Becoming Fluent In Options On Futures.)

Most futures contracts are offset prior to delivery, meaning that most contracts are speculators trying to profit off of price movements.

Advantages of Futures Contracts
Unlike equities, futures contracts can be shorted on a downtick, which gives market participants greater flexibility. This flexibility allows hedgers to protect their physical position and speculators to take a position based on market expectations.

Because the soft commodity markets are traded at an exchange, the clearing services ensure no default risk. This means that the exchange acts as buyer to every seller should a market participant have to default on its responsibilities.

Market Personality
With the merger of the NYBOT and Intercontinental Exchange (ICE) in 2007, and after these markets went electronic, volume increased substantially.

Contract Specifications
Although there are other sugar and coffee contracts that trade around the world, this piece deals only with those traded at the ICE Futures U.S.

1. Cocoa
Discovered by the natives of Central America more than 3,000 years ago, cocoa was originally a luxury for the very rich. Today, most of the world's cocoa is grown in a handful of countries: the Ivory Coast, Ghana, Indonesia, Brazil, Ecuador and Nigeria.

Cocoa is traded in dollars per metric ton and one contract is for 10 metric tons. For example, when cocoa is trading at $1,500/M ton, the contract has a total value of $15,000. If a trader is long at $15,000/M ton, and the markets move to $1,555/lb, that is a move of $550 ($1,500 - $1,555 = $55, and 55 x 10 M ton. = $550).

The minimum price movement, or tick size, is a dollar, or $10 per contract. Although the market frequently will trade in sizes greater than a dollar, one dollar is the smallest amount it can move.

The contracts month for delivery of sugar are March, May, July, September and December. Delivery points include licensed warehouses in the Port of New York District, Delaware River Port District, Port of Hampton Roads, Port of Albany or Port of Baltimore.

2. Coffee
Coffee was originally discovered in Ethiopia more than 2,000 years ago. From Africa, coffee found its way to the Middle East and into coffee houses. It was these coffee houses that gave coffee its exposure to many travelers, which spread its use outside the Arabian borders.

Coffee is traded in cents per pound. One contract of coffee controls 37,500 pounds of coffee. When the price of coffee is trading at $1/pound, the cash value of that contract will be $37,500 ($1.00 x 37,500 = $37,500).

The tick size is 5 cents per pound, which equates to $18.75 per tick. For example, if a trader were to go long at $1.1000 and the markets moved to $1.1550, he would have a profit of $2062.50 ($1.1550 - $1.1000 = $0.0550, and $0.0550 x 37,500 = $2,062.50).

Because it one of the larger contracts in dollar terms, little movements have a big impact on price. Coffee has one of the larger daily ranges of all the softs, making it a very volatile commodity.

Coffee is deliverable in March, May, July, September and December. Delivery points are worldwide in ports around the globe like New Orleans, New York, Houston, Miami, Hamburg, Antwerp and Barcelona.

3. Cotton
Because cotton has universal appeal and can be used in many different products, it has been one of more influential commodities. Discovered more than 5,000 years ago, cotton has played a vital role in the rise and fall of many countries. It was one of America's first cash crops.

Cotton is traded in 50,000-pound contracts. It is also traded in cents per pound, so if the market is trading at 53 cents per pound, the contract will have a value of $26,500 ($0.53 x 50,000 pounds = $26,500).

The minimum tick size is $0.0001 or $5 per contract. Therefore any 2 cent move in cotton will equate to either a gain or a loss of $1,000. When the price of cotton exceeds 95 cents per pound, the minimum tick movement will expand to $0.0005 to accommodate to the larger daily ranges.

March, May, July, October and December are the contract months for cotton. Delivery points are in Galveston, Houston, New Orleans, Memphis and Greenville/Spartanburg, which isn't too surprising considering that is where most of it is grown.

4. Frozen Concentrated Orange Juice
Orange juice is a relative newcomer to the commodity markets. For centuries, OJ was consumed as fresh fruit juice because it had a relatively short shelf life and was susceptible to price shocks due to supply disruptions. Freezing OJ was invented in the 1940s and quickly became the industry standard.

One contract of FCOJ equals 15,000 pounds. If the current market price is 90 cents per pound, the contract has a value of $13,500 ($0.90 x 15,000 pounds = $13,500).

The minimum tick is $0.005, or $7.50 per tick per contract. For example, let's say you buy a contract of FCOJ when the market is at 95 cents, and then sell it for $1. In this transaction, you would make $750 on the 5 cent move in FCOJ.

Oranges that come from Brazil and Florida are deliverable in exchange-licensed warehouses in Florida, New Jersey and Delaware only. FCOJ is most actively traded in January, March, May, July, September and December.

5. Sugar
It is widely believed that humans first used sugar well over 2,000 years ago. Originally only reserved for the very rich, sugar has become one of the more common staples on the dinner table. Because of its mass appeal, sugar is usually one of the most heavily traded commodities in the world in terms of total volume.

Sugar trades in contracts of 112,000 pounds as well as in cents per pound. If the futures price is $0.1045, the contract has a value of $11,704 ($0.1045/lb x 112,000 pounds = $11,704). If the market moves from $0.1000 to $0.1240, that is equivalent to a dollar move of $2,688.

The minimum price movement for sugar is $0.0001 or $11.20 per contract.

Sugar is only deliverable in March, May, July and October. There are delivery points in each nation where the sugar is produced. These are places like Argentina, Australia, Barbados, Belize, Brazil, Colombia, Costa Rica, Dominican Republic, El Salvador, Ecuador, FijiIslands, French Antilles, Guatemala, Honduras, India, Jamaica, Malawi, Mauritius, Mexico, Mozambique, Nicaragua, Peru, Republic of the Philippines, South Africa, Swaziland, Taiwan, Thailand, Trinidad, United States and Zimbabwe. (To find out more about global trends in these commodities, see Taking Global Macro Trends To The Bank.)

Conclusion
There are many different opportunities in soft commodities markets. Any person looking to invest should carefully consider the risk involved and be aware of the contract specifications before investing.

To read more about commodities, see Commodities: The Portfolio Hedge, Commodity Prices And Currency Movements and Who sets the price of commodities?

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