Market side: Futures trading basics

This monthly educational series will feature the basic workings of the futures and options markets and how they can be utilized to help farmers with risk management.

THE MCCORMICK REAPER started a revolution in wheat marketing that eventually lead to higher wheat production in the U.S. It was designed by Robert McCormick in Walnut Grove, Virginia and perfected and patented by his son Cyrus McCormick in 1837. With the new era of telegraph and railway lines, Chicago had become a bustling commercial centre and saw the opening of a central marketplace where Midwest farmers converged in the 1840s hoping to sell their grain at a good price to dealers who, in turn, shipped it across the country.

Because there were few storage facilities in the city and no established procedures either for weighing the grain or for grading it, the farmer was often at the mercy of the dealer. Farmers (sellers) and dealers (buyers) began to commit to future exchanges of grain for future delivery. As time progressed, the farmer would agree with the dealer on a price to deliver to him a set quantity of grain at a predetermined date in the future. These forward contracts were private contracts between buyers and sellers and became the forerunner of today’s exchange-traded futures contracts. Both forward contracts and futures contracts are legal agreements to buy or sell an asset on a specific date or during a specific month. Whereas forward contracts are negotiated directly between a buyer and a seller and settlement terms may vary, futures contracts are specific to that commodity and are non-negotiable.

The bargain suited both parties. The farmer knew how much he would be paid for his wheat, and the dealer knew his costs in advance. The two parties may have exchanged a written contract to this effect and even a small amount of money representing a “guarantee.”

Such contracts became common and were even used as collateral for bank loans. They also began to change hands before the delivery date. If the dealer decided he didn’t want the wheat, he would sell the contract to someone who needed it. Or, the farmer who didn’t want to deliver his wheat might pass his obligation on to another farmer. The price would go up and down depending on what was happening in the wheat market. If the weather became an issue, the buyer of the wheat would benefit because the supply would be lower resulting in higher prices and inversely if the harvest were bigger than expected, the contract seller would benefit due to a larger harvest and lower prices in the coming months.

Eventually, people who had no intention of ever buying or selling wheat began trading these contracts in hopes of making a profit on price fluctuations. They were speculators, hoping to buy low and sell high or sell high and buy low. This extra source of buyers and sellers (liquidity) became an important component in what would eventually become today’s futures markets. •

Marty Hibbs is a 25 year veteran futures trader, analyst, and portfolio manager. Hibbs was a regular guest analyst on BNN for four years. He is currently a grain merchandiser with Grain Farmers of Ontario.

Lesson Definitions: Futures: Standardized contracts for the purchase and sale of various financial instruments or physical commodities for future delivery on a regulated commodity futures exchange. Forward Contract: A private, cash-market agreement between a buyer and seller for the future delivery of a commodity, at an agreed upon price. In contrast to futures contracts, forward contracts are not standardized and are non-transferable. Spot Market: A market where cash transactions for the physical or actual commodity occur.