Temperature, precipitation and the changing needs of customers all contribute to the supply and demand for commodities like wheat, corn or soybeans. All of these changes greatly affect the price of commodities, and the grain markets are essential to managing these price swings and providing global benchmark prices. Read on to dig into and learn about the seven major products of the grain markets. (See also: Futures Fundamentals.)
What Are Grain Futures Contracts?
Anyone looking to invest in futures should know that the risk of loss is substantial. This type of investment is not suitable for everyone. An investor could lose more than originally invested and, therefore, only risk capital should be used. Risk capital is the amount of money that an individual can afford to invest, which, if lost would not affect the investor's lifestyle.
A grain futures contract is a legally binding agreement for the delivery of grain in the future at an agreed-upon price. The contracts are standardized by a futures exchange as to quantity, quality, time and place of delivery. Only the price is variable.
There are two main market participants in the futures markets: hedgers and speculators. Hedgers use the futures markets for risk management and withstand some risks associated with the price or availability of the actual underlying commodity. Futures transactions and positions have the express purpose of mitigating those risks. Speculators, on the other hand, generally have no use for the commodities in which they trade; they willingly accept the risk involved in investing in futures in return for the prospect of dramatic gains.
Advantages of Futures Contracts
Financial leverage is the ability to trade and manage a high market value product with a fraction of the total value. Trading futures contracts is done with performance margin; therefore, it requires considerably less capital than the physical market. Leverage provides speculators a higher risk/higher return investment.
For example, one futures contract for soybeans represents 5,000 bushels of soybeans. Therefore, the dollar value of this contract is 5,000 times the price per bushel. If the market is trading at $5.70 per bushel, the value of the contract is $28,500 ($5.70 x 5,000 bushels). Based on current exchange margin rules, the margin required for one contract of soybeans is only $1,013. So for approximately $1,013, an investor can leverage $28,500 worth of soybeans.
Advantages of Grain Contracts
Because grain is a tangible commodity, the grain market has a number of unique qualities. First, when compared to other complexes like the energies, grains have a lower margin making it easy for speculators to participate. Also, grains generally aren't one of the bigger contracts (in terms of total dollar amount), which accounts for the lower margins.
The fundamentals in the grains are fairly straightforward: like most tangible commodities, supply and demand will determine the price. Weather factors will also have an effect.
There are seven different grain products traded at the Chicago Board of Trade: corn, oats, wheat, soybeans, rice, soybean meal and soybean oil.
Similar grain products trade in other commodities markets around the world, such as Minneapolis, Winnipeg, Hong Kong, Brazil and India to name a few.
1. Corn: Corn is used not only for human consumption but to feed livestock such as cattle and pigs. Also, higher energy prices has led to using corn for ethanol production.
The corn contract is for 5,000 bushels, or roughly 127 metric tons. For example, when corn is trading at $2.50 a bushel, the contract has a value of $12,500 (5,000 bushels x $2.50 = $12,500). A trader that is long $2.50 and sells at $2.60 will make a profit of $500 ($2.60 - $2.50 = 10 cents, 10 cents x 5,000 = $500). Conversely, a trader who is long at $2.50 and sells at $2.40 will lose $500. In other words, every penny difference equals a move up or down of $50.
The pricing unit of corn is in dollars and cents with the minimum tick size of $0.0025, (one-quarter of a cent), which equals $12.50 per contract. Although the market may not trade in smaller units, it most certainly can trade in full cents during "fast" markets.
The most active months for corn delivery are March, May, July, September and December.
Position limits are set by the exchange to ensure orderly markets. A position limit is the maximum number of contracts that a single participant can hold. Hedgers and speculators have different limits. Corn has a maximum daily price movement.
2. Oats: Oats are not only used to feed livestock and humans, but are also used in the production of many industrial products like solvents and plastics.
An oats contract, like corn, wheat and soybeans, is for the delivery of 5,000 bushels. It moves in the same $50/penny increments as corn. For example, if a trader is long oats at $1.40 and sells at $1.45, he or she would make 5 cents per bushel, or $250 per contract ($1.45 - $1.40 = 5 cents, 5 cents x 5,000 = $250). Oats also trades in quarter-cent increments.
Oats for delivery are traded March, May, July, September and December, like corn. Also like corn, oats futures have position limits.
Oats is a difficult market to trade because it has less daily volume than any other market in the grain complex. Also its daily range is fairly small.
3. Wheat: Not only is wheat used for animal feed, but also in the production of flour for breads, pastas and more.
A wheat contract is for delivery of 5,000 bushels of wheat. Wheat is traded in dollars and cents and has a tick size of a quarter cent ($0.0025), like many of the other products traded at the CBOT. A one-tick price movement will cause a change of $12.50 in the contract.
The most active months for delivery of wheat, according to volume and open interest, are March, May, July, September and December. Position limits also apply to wheat.
Next to soybeans, wheat is a fairly volatile market with big daily ranges. Because it is so widely used, there can be huge daily swings. In fact, it is not uncommon to have one piece of news move this market limit up or down in a hurry.
4. Soybeans: Soybeans are the most popular oilseed product with an almost limitless range of uses, ranging from food to industrial products.
The soybean contract, like wheat, oats and corn, is also traded in the 5,000 bushel contract size. It trades in dollar and cents, like corn and wheat, but is usually the most volatile of all the contracts. The tick size is one-quarter of a cent (or $12.50).
The most active months for soybeans are January, March, May, July, August, September and November.
Position limits apply here as well.
Beans have the widest range of any of the markets in the grain room. Also, it will generally be $2 to $3 more per bushel than wheat or corn.
5. Soybean Oil: Besides being the most widely used edible oil in the United States, soybean oil has uses in the bio-diesel industry that are becoming increasingly important.
The bean oil contract is for 60,000 pounds, which is different from the rest of the grain contracts. Bean oil also trades in cents per pound. For example, let's say that bean oil is trading at 25 cents per pound. That gives a total value for the contract of $15,000 (0.25 x 60,000 = $15,000). Suppose that you go long at $0.2500 and sell at $0.2650; this means that you have made $900 ($0.2650 - 25 cents = $0.015 profit, $0.015 x 60,000 = $900). If the market had gone down $0.015 to .2350, you would lose $900.
The minimum price fluctuation for bean oil is $0.0001, or one one-hundredth of a cent, which equals $6 per contract.
The most active months for delivery are January, March, May, July, August, September, October and December.
Position limits are enforced for this market as well.
6. Soymeal: Soymeal is used in a number of products, including baby food, beer and noodles. It is the dominant protein in animal feed.
The meal contract is for 100 short tons, or 91 metric tons. Soymeal is traded in dollars and cents. For example, the dollar value of one contract of soymeal, when trading at $165 per ton, is $16,500 ($165 x 100 tons = $16,500).
The tick size for soymeal is 10 cents, or $10 per tick. For example, if the current market price is $165.60 and the market moves to $166, that would equal a move of $400 per contract ($166 - $165.60 = 40 cents, 40 cents x 100 = $400).
Soymeal is delivered on January, March, May, July, August, September, October and December.
Soymeal contracts also have position limits.
7. Rice: Not only is rice used in foods, but also in fuels, fertilizers, packing material and snacks. More specifically, this contract deals with long-grain rough rice.
The rice contract is 2,000 hundred weight (cwt). Rice is also traded in dollars and cents. For example, if rice is trading at $10/cwt, the total dollar value of the contract would be $20,000 ($10 x 2,000 = $20,000).
The minimum tick size for rice is $0.005 (one half of a cent) per hundred weight, or $10 per contract. For example, if the market was trading at $10.05/cwt and it moved to $9.95/cwt, this represents a change of $200 (10.05 - 9.95 = 10 cents, 10 cents x 2,000 cwt = $200).
Rice is delivered in January, March, May, July, September and November. Position limits apply in rice as well.
The primary function of any commodity futures market is to provide a centralized marketplace for those who have an interest in buying or selling physical commodities at some time in the future. There are a lot of hedgers in the grains markets due to the many different producers and consumers of these products. These include, but are not limited to, soybean crushers, food processors, grain and oil seed producers, livestock producers, grain elevators and merchandisers.
Using Futures and Basis to Hedge
The main premise upon which hedgers rely is that although the movement in cash prices and futures market prices may not be exactly identical, it can be close enough that hedgers can lessen their risk by taking an opposite position in the futures markets. By taking an opposite position, gains in one market can offset losses in another. This way, hedgers are able to set price levels for cash market transactions that will take place several months down the line.
For example, let's consider a soybean farmer. While the soybean crop is in the ground in the spring, the farmer is looking to sell his crop in October after the harvest. In market lingo, the farmer is long a cash market position. The farmer's fear is that prices will go down before he can sell his soybean crop. In order to offset losses from a possible decline in prices, the farmer will sell a corresponding number of bushels in the futures market now and will buy them back later when it is time to sell the crop in the cash market. Any losses resulting from a decline in the cash market price can be partially offset by a gain from the short in the futures market. This is known as a short hedge.
Food processors, grain importers and other buyers of grain products would initiate a long hedge to protect themselves from rising grain prices. Because they will be buying the product, they are short a cash market position. In other words, they would buy futures contracts to protect themselves from rising cash prices.
Usually there will be a slight difference between the cash prices and the futures prices. This is due to variables such as freight, handling, storage, transport and the quality of the product as well as the local supply and demand factors. This price difference between cash and futures prices is known as basis. The main consideration for hedgers concerning basis is whether it will become stronger or weaken. The final outcome of a hedge can depend on basis. Most hedgers will take historical basis data into consideration as well as current market expectations.
The Bottom Line
In general, hedging with futures can help the future buyer or seller of a commodity because it can help protect them from adverse price movements. Hedging with futures can help to determine an approximate price range months in advance of the actual physical purchase or sale. This is possible because cash and futures markets tend to move in tandem, and gains in one market tend to offset losses in another.