When financial experts speak of commodity markets they often discuss futures markets. But for a layperson like me, I didn’t really understand how “futures” work or how they influence commodity markets. I would like to share a bit of the basics that I have learned with you.
A futures transaction involves trading a future contract based on physical cotton at a price determined in an open auction – the futures market. Traders engage in the futures market primarily to manage their risk or speculation, with few intending to take possession of physical cotton.
The futures contract is a legally binding commitment to deliver or receive a specific quantity and grade of cotton – or its cash equivalent – to a certain location on a specified date. The futures contract standardizes terms of cotton quality and grade, representing the average price for an average range of qualities.
The futures price reflects current and prospective supply and demand scenarios. This price is different from the spot price in the physical market, which refers to the price of cotton for immediate delivery.
The physical premium or discount (the differential between the futures price and the spot price) represents the market value compared to the futures market. Futures cannot be used to moderate the differential or basis risk (imperfect hedging using futures from differences between the asset whose price is to be hedged and the asset underlying the derivative, or a mismatch between the futures’ expiration date and the asset sale date (Wikipedia). for a particular bale, grade or quantity of cotton. However, futures can help manage exposure to price risk because they represent the supply and demand for an average grade of widely available cotton.
Futures can be traded through floor-based trading, in which the initiation of a contract transaction takes place on the floor of the exchange using hand signals and verbal calls. The transaction is negotiated across the floor, giving all parties an opportunity to bid. No private transactions are allowed. Trading ends when a buyer and seller agree to conditions and register the contract with the clearing house. The clearing house is involved in all transactions. Automated or electronic trading follows the same principles and as well as the same clearing procedure.
An exchange is long when a trader buys a futures contract and has no other position on the exchange. A trader who sells a future without offsetting the transaction with another purchase is short. The total of the clearing house’s long and short positions outstanding at a given time is called the open interest. The clearing house guarantees the performance of both sides of all open contracts to its members.
Types of orders:
Fixed price orders for the same day state the particular month at a set price (e.g. 100 bales for February at $1.27 per pound). The contract must be signed on the same day that the order is given.
Fixed price, open orders are similar to same day orders, but the terms apply to an indefinite period of time. These are also referred to “good till cancelled” (GTC) orders.
Market orders allow brokers to make a contract for the best possible price at the time of purchase.
I share the above information at face value. I have not been involved in the futures market so I am certain that there is much more to futures trading and their impact on global trade than the little introduction I have presented. I welcome your input and comments.
Is the above summary a constructive overview of futures basics? If not, what is missing or should be considered?
Is the global cotton trade positively or negatively impacted by a futures market?