DTN® Price Risk Management Curriculum

Table of Contents

Preface 1

Module I - What is a Market? 3 What is a market? 3 Introduction 3 Market History 3 Market Participants 6 Market Types 7 Market Trends 8 Establishing a Price 8

Module II - Understanding Market Tools 11 Introduction to Hedging Strategies 11 Cash Transactions 12 Cash Sales 12 Forward Contracts 12 Basis Contract 13 Hedge-To-Arrive (HTA) or Futures First Contract 13 Futures Contracts 14 Short Hedge 14 Long Hedge 15 Options on Futures Contracts 15 Option 15 Put Option 17 Call Option 17 Other Methods 17 Government Programs 17 Commodity Loan Program 18 Insurance 19

Module III - What to Watch for in a Market (The 6 Factors) 20 Traditional Market Analysis 20 Fundamental Analysis 20 Technical Analysis 20 Traditional Analysis Flaws 20 Introduction to DTN's Six Factor Analysis 21 Trend 21 Open Interest 22 Seasonal Index 24 Basis 27 Price Probability 29 Volatility 29 Six Factor Summary 30 Example 1 32 Example 2 34

Glossary 36

Preface

enjamin Franklin said the only In this course we will study a differ- If that had happened—and it could two certainties in life are death ent kind of financial risk. We will focus have—waiting to buy the car could Band taxes. With all respect to this on a type of risk all of us run, in both have cost you money. great American, there is in fact a third our business and personal lives—the In the business world price risks certainty: risk. risk that the price of something we buy abound, and businesses as a Every day, every human being or sell will change to our disadvantage consequence employ a variety of confronts risk. Risk is the chance, the sometime in the future. This is called risk-management techniques. Some possibility, that something could go “price risk,” and we are going to be are as simple as timing purchases, as wrong and cause pain, suffering, discussing both the nature of price risk in the car example just discussed. disease, emotional distress, financial and some of the “risk management” Others are more complex. A local fuel loss, destruction or loss of property, stratagems and tools that we can use distributor in a rural area might offer a or even death. There’s no avoiding it. to protect ourselves against it. guaranteed fixed price if customers Mankind has struggled with risk An example from everyday life illus- agree to buy all of their needs from since Adam and Eve. Greek and trates how widespread this risk is and the distributor for a year. To protect Roman literature is replete with refer- how, without even thinking about it, we itself from an increase in the price it ences to the cruel workings of Fate; the practice “risk management.” Let’s say in turn pays for the fuel, the distributor ancients believed that in some cases, you have been considering buying a might buy what’s called a futures the realization of risks was predestined car. From discussions with your friends contract. As we will learn when we and inevitable. and research on the Internet you have study futures contracts in detail, this decided which model to buy, and by will “lock in” the distributor’s price: In more recent centuries, as carefully managing your budget you He gets the security of knowing that advances in science and technology have saved up enough money to make he will not have to pay more if the have given humankind a greater sense the down payment. You are just about market price rises above the futures of control over our destiny, we have to head on down to the car dealer’s contract price. In return, he gives up invented ways of averting, minimizing, when a headline in the newspaper the possibility of paying less should mitigating or at least coping with the catches your attention: “Car Sales market prices fall below the futures consequences of risk. For example, Down 10% in June.” governments have enacted laws and contract price. You read on and learn that the sales regulations aimed at promoting health slowdown is causing inventories to and safety. build up on dealers’ lots. Moreover, In the private sector, to cite another economists expect the sales downturn example, people have joined together to worsen before it improves again. to create companies that offer insur- Pondering this news, your first thought ance against such risks as sickness, fire, is that the car industry’s bad news injury-causing accidents, even death. might be good news for you; the dealer By buying an insurance policy from may be willing to give you a better one of these companies, you protect price. Before rushing out to the dealer’s, yourself against some or all of the though, you consider the economists’ financial consequences of these risks. prediction of continued slow sales: “If If your house burns down and you have I wait a few weeks, the price may come fire insurance, you receive money to down even more. There might even be help rebuild. If you die holding a life- rebates.” Two months later you finally insurance policy, your dependents make the purchase, and in this case receive payments to make up for the your patience is rewarded with a savings income you can no longer provide. of several hundred dollars. Insurance companies employ Anticipating the most favorable time specialists called actuaries who try to for a transaction is perhaps the simplest calculate, judging from past experience, form of price-risk management. how likely an insured-against risk is to Waiting to buy the car in this example occur. This enables the companies to may not seem to involve much risk but price insurance so that the companies it does involve some. What if a sudden will be able to pay off claims as they surge in demand drove prices up, con- arise and still earn a profit. trary to the economists’ expectations? 1

Preface (continued)

A U.S. meat packer with operations the broad concepts of price-risk own farmland and need to know how in Canada might well worry that any management. your tenants protect themselves. You Canadian dollar profits the packer In Module I, What Is a Market, we may become a business person and earns might be worth less in U.S. will sketch out the basic ideas and need to lock in the price of a key dollars should the Canadian currency define the most important terms. Think production input. You may invest in decline in value against the U.S. dollar. of this as a kind of crash course in supply- the stock market and want to know To protect against this risk the packer and-demand economics and the tools how to leverage your investment might sell a Canadian dollars futures for coping with changes in market through the use of options on stock. contract, guaranteeing that even in the dynamics. Module II, Understanding Whatever profession you ultimately event of such a decline the packer’s Market Tools, will describe the different take up, whatever course your personal Canadian dollar profits would buy the ways market participants have available life takes, you will be a more effective same number of U.S. dollars. to protect themselves against adverse business person, a more successful As these two examples illustrate, price movements. Module III, What to investor and a smarter consumer if you futures contracts can work both ways. Watch for in a Market, will explain how understand price-risk management. Someone who expects to buy some- we at DTN simplify market analysis by You probably won’t remember all the thing can buy a futures contract to reducing the thousands of interacting details, but by putting some effort into protect against price rises; someone factors affecting markets to the six that the lessons that follow you will likely who has something she expects to sell really matter. retain a firm grasp of the basic con- in the future can use a futures contract Chances are you will someday find cepts and be able to brush up on the to protect against a price decline. yourself in a situation where price-risk specifics quickly when necessary. But what if you want to protect management stratagems will be useful. We have written these lessons with yourself against an adverse price move You may become a farmer and need to an eye toward making that effort as without giving up the chance to profit protect yourself from price volatility, or fruitful as possible for you. from a favorable one? You can do that, too, but you will have to pay for the privilege. You would do it by using a different kind of risk-management tool: options. A soybean farmer who hopes to benefit from a rise in prices while ensuring a minimum price in case soybean prices fall could buy what’s called a put option. In a future lesson we will talk about how options work in detail, but in general terms they give more flexibility and protection than futures contracts, but at a price—the so-called options premium. In the lessons that follow, we will talk about price-risk management in an agricultural context. Specifically, our focus will be on how farmers, ranchers and other producers of agricultural products can use price-risk management to get good prices for their products. But it is important to understand that the same principles apply to a wide variety of risk-management situations that may arise in your personal and business life. So while we ask you to work through the arithmetic of some specific agricultural examples as a test of your understanding, our main focus will be on making sure you understand 2

Module I - What is a Market?

Introduction Market History products. Slowly over time, the need for a more formalized way to trade hen farmers and ranchers Exchanging of goods goes back to the evolved, requiring measurement stan- talk of marketing, they most earliest civilizations, pre-dating money. dardization and a common currency. Bartering is the exchange of goods Woften use the word in the As circumstances changed, buyers or services for mutual advantage. ancient sense of taking products to and sellers began to look for a way to No money changes hands in barter, as market to sell, as when a grain farmer guarantee their products or payments one simply trades his product or service hauls his truckload(s) of grain to the outside of the current-cash marketing for another’s. This ancient method of local grain elevator and receives a method, where a seller gets what the exchange worked thousands of years payment for his product. buyer is willing to pay on the day of ago and still is practiced today. If the farmer is a “good” marketer, sale. A logical first step was forward Nowadays, a neighbor may offer to he will take additional steps to ensure contracting, which allowed sellers to mow his neighbor’s lawn in exchange he gets a good price for his products guarantee their payments by locking in for his computer-savvy neighbor fixing by price shopping, locking in a price or a set price with their buyers before his haywire PC. Even organizations other price-risk management measures. barter. A charity group may give out they delivered the product. The buyers Nowadays the broader business t-shirts or concert tickets in order to also benefited, as forward contracting world defines marketing as communi- get people to volunteer or help raise gave them a guaranteed supply at a cations with customers and potential funds for its cause. pre-determined price. Gradually, cash customers aimed at increasing markets evolved even further into Over the centuries, cultures became organized futures markets. demand. Marketing, in this sense, more agrarian and less nomadic, thus takes on many forms such as advertising lending themselves to marketplaces In the case of agricultural commodities, campaigns, public relations events, where wares could be brought to a Chicago took a major role in the devel- direct mail or phone calls, as well as centralized place to sell and money opment of an organized market in the other tactics designed for the target could be used to pay for these 1800s. Strategically located at the audience. It has only been in the last few DID YOU KNOW? decades that trade associations representing agricultural commodities like Checkoffs are controversial. Some agricultural producers love them. They beef, eggs and sugar have begun to reason that as relatively small producers of commodities that are hard to do this kind of marketing, under the brand or otherwise distinguish from other commodities, they would be auspices of checkoff programs. unable to afford modern marketing communications on their own. The A checkoff program is an industry- only way to increase demand, in their view, is for all producers to market funded generic marketing, research commodities collectively. It makes sense to them that as all producers of and new-product development pro- the commodity will benefit from the increased demand; all should have to gram aimed at increasing demand for pay for it. an agricultural commodity. Checkoff programs were established by acts of Other producers dislike checkoffs. In some cases, this is because they Congress, and the USDA’s Agricultural have found a way to brand or distinguish what they produce. An Angus Marketing Service (AMS) has primary cattleman, for example, might see it in his interest to increase demand oversight responsibilities. USDA’s for Angus beef rather than “generic” beef. He might thus resent having Foreign Agricultural Service (FAS) to pay for generic beef advertising. provides additional oversight Some checkoff opponents have filed lawsuits challenging checkoff pro- responsibilities for checkoff-program grams on the grounds that they violate the opponents’ constitutional right activities in global markets. to freedom of speech and freedom of association. In some cases the U.S. Like any marketing program, Supreme Court has ruled checkoff programs unconstitutional; in other the checkoff-funded programs are cases the Supreme Court has upheld the programs against constitutional designed to increase demand for challenge. Much depends on the precise nature of the checkoff program an agricultural commodity, which producers hope to reap in an increased and the kinds of arguments competing lawyers make. The litigation is often price for their product when they take complicated and may take years to resolve. it to market. 3

Module I - What is a Market? (continued) lower end of Lake Michigan and in Due to the increase of grain trading, agreements created futures contracts close proximity to the abundant farm the Board of Trade of the City of and set the stage for futures markets. land of Illinois, the growing city became Chicago was organized in 1848. Gradually the Board of Trade extended a transaction center for grains grown Its goal was to promote commerce on its control and developed further rules, nearby to be sold and shipped east. the Illinois Michigan Canal, which had driven by disputes and other problems. been completed in 1847. In 1849, the As settlers homesteaded land farther It seemed to some that futures state legislature granted the Board of west, they created the need for local contracts offered very little benefit. Trade a special charter that allowed it merchants, people who could buy grain The government initially took a to develop quality standards and to from the settlers to resell in Chicago. negative view, seeing only feverish measure, gauge, weigh and inspect speculation, huge price fluctuation and Roads, canals and railroads spread out grain. The charter also allowed the consternation for farmers. From the from the trading hub of Chicago, and Board to arbitrate disputes among 1860s until the early 1900s, state and as a result grain and livestock converged commodity merchants. The city’s mer- federal legislators introduced bills to in Chicago, which became the central chants adopted the Board’s procedures abolish or tax futures trading out of market place for the West to sell its to handle grain in bulk rather than in existence, but none passed. commodities to the East. bags, as traditionally had been the case. Opposition against the futures market By the early 1850s, the local The enforced standards made the was highest when prices were at their merchants began to sell corn to the process of grain buying and selling and lowest and lowest when prices rose. Chicago merchants on time contracts the trading of forward contracts more As US agriculture grew along with or forward contracts to minimize their efficient. Consequently, Chicago’s grain trade, it became apparent that the price risk. A forward contract specifies traders gained national recognition as futures market had a major role in this the amount of commodity, in this case a reliable and competitively priced continued growth. corn, to be sold at a set future date at source of grain during the 1850s. In 1922 the Grain Futures Act an agreed-upon price. These contracts In addition to the measurement stan- was passed. This law allowed the guaranteed a local merchant a market dards, the Board of Trade established government some control over the for the corn and told him how much to a meeting place and regular trading exchanges by requiring them to be buy from the farmers and at what price, hours, which moved the transactions licensed and barring price manipulation minimizing the chance he might pay off the streets. by their members. Additionally, the law provided for a continuous supply of trad- too much when he bought the corn Even with the more formalized ing information. Fourteen years later, the locally or not have a buyer when he location and hours of trading, there law was amended with the Commodity later went to sell the corn in Chicago. was still little control over the trading Exchange Act of 1936, which dealt with of futures contracts, but the need for As forward contracts became a com- market abuses by traders, commission control was apparent. When it came mon way of doing business, speculators merchants and exchange members. joined the buyers and sellers in the mar- time to settle contracts, some people ketplace. Speculators didn’t intend to didn’t show and others couldn’t pay. buy or sell corn, but dealt instead in the In 1865, the Board of Trade, acting DID YOU KNOW? forward contracts themselves, in the within its charter, issued general rules requiring a “good faith” deposit, or Cattle, which included anything hopes of making a profit on the resale margin, to discourage no shows. from cows to sheep to camels, of the contracts. Speculation became a viable business activity and continues to In addition, the rules standardized were the first form of “money,” be one for those skilled enough to sell contract terms for quantity and quality dating back to 9000-6000 BC. consistently at a higher price than they of commodity, delivery procedure and With the onset of agriculture payment terms. It was this standardiza- paid. With the speculators in the game, came the use of grain and other tion that marked the difference contracts could trade hands many times between forward contracts and futures vegetable and plant products as before the actual delivery of the corn contracts. Forward contracts, for standard items of barter in many took place. During the infancy of corn example, might cover any amount of cultures. The first metal coins used forward contracts, the buyers, sellers grain the buyer and seller had agreed as money, bronze and copper and speculators converged in public upon. Futures contracts are all for the coins manufactured in China, only squares and on street curbs to negoti- same amount of grain, with the specific ate. Wheat forward contracts followed amounts for specific grains set out in date as far back as 1000 BC—the suit and were also commonplace in the standardized contract terms. The end of the Stone Age. Chicago in the early 1850s. implementation of these standardized 4

Module I - What is a Market? (continued)

Under this Act, price manipulation The Commodity Exchange Act of primarily with butter, eggs, poultry and became a criminal offense, increasing 1981 established the National other farm products. Later, the name Congress’ regulatory sway. Futures Association (NFA), an organi- changed to the Chicago Butter and Additional amendments were later zation charged with regulating the Egg Board and in 1919 acquired the made to the 1936 law, but the next activities of its members—brokerage name by which we know it today, the major Act did not pass until 1974—the houses and their agents. Chicago Mercantile Exchange. Commodity Futures Trading Act. The This standardized trading evolution In addition to those mentioned, 1974 Act created an independent fed- wasn’t confined to Chicago. Forward many other commodity exchanges eral body, the Commodity Futures contracts of cotton were reported in have been organized since 1848, Trading Commission (CFTC), to over- New York in the 1850s, 20 years only some of which still exist today. see all futures trading in the U.S. The CFTC is the federal regulatory agency ahead of the New York Cotton The development of futures trading of the Department of Agriculture that Exchange. Additionally, formalized evolved from the circumstances and monitors the trading in futures and grain exchanges cropped up in market needs of the times and is still options on futures markets in the U.S. Minneapolis, Duluth, Milwaukee, evolving today. Some commodities The CFTC requires the futures Omaha, Kansas City, St. Louis, have been traded for more than 100 exchanges to obtain CFTC approval for Toledo, Baltimore, San Francisco years, others are relatively new—all any regulatory changes or for the intro- and New York. are examples of a continually evolving duction of new futures contracts and Grain and cotton weren’t the only marketplace. For instance, some options. The CFTC also approves trad- commodities traded. In 1874, trading is now electronic, and in some ing rules, contract terms and discipli- merchants formed the Chicago cases the buyer and seller make their nary procedures. Produce Exchange, which dealt trades via the Internet.

CURRENT NORTH AMERICA COMMODITY EXCHANGES (Partial List) Exchange Established Current Commodity Web Address Contracts Traded Chicago Board 1848 Corn, Soybeans, Soybean Oil, http://www.cbot.com of Trade (CBOT) Soybean Meal, Wheat, Ethanol, Oats, Rough Rice

New York Mercantile 1872 Crude Oil, Natural Gas, http://www.nymex.com Exchange (NYMEX) Heating Oil, Gasoline

Chicago Mercantile 1874 Live Cattle, Feeder Cattle, http://www.cme.com Exchange (CME) Lean Hogs, Class III Milk, Cheese, Butter, Pork Bellies, Lumber

Kansas City 1876 Wheat http://www.kcbt.com Board of Trade (KCBT)

Minneapolis Grain 1881 Hard Red Spring Wheat, http://www.mgex.com Exchange (MGEX) DTN National Soybean Index, (originally founded as the DTN Hard Red Spring Wheat Index, Minneapolis Chamber of DTN Hard Red Winter Wheat Index, Commerce) DTN Soft Red Winter Wheat Index

Winnipeg Grain (& Produce) 1891 Canola, Feed Wheat, Flax, http://www.wce.ca Exchange (WGE) Western Barley

New York Board 1998 Coffee, Sugar, Cocoa, Cotton, http://www.nybot.com of Trade (NYBOT) Frozen Concentrated Orange Juice, Currencies

Module I - What is a Market? (continued) Market Participants and sell contracts on the floor or in the Each exchange has a clearing house. pits of exchange. Transactions on A clearing house is the department or In order for a market to exist, there some exchanges are made by open agency of a futures exchange that is are some essential players who need outcry, which means that all trading is responsible for the daily settlement of to participate, just as a baseball game done publicly so that each trader has a all customer accounts. The clearing can’t be played without some integral chance to buy and sell. Open outcry is house guarantees all contracts by team members. The two broad cate- a sight to see: dozens of traders, at the matching purchases and sales, assuring gories of market participants are buyers opening bell, signaling the opening of proper conduct of delivery procedures and sellers. A buyer is one who is trading time, using their voices and and maintaining adequate financing by looking to buy goods or services. hand signals to communicate with member firms. A seller is one who is looking to sell other traders. During trading time People who use futures exchanges to goods or services. Without a buyer, these pits are frenzied as traders buy reduce the risk of actual commodity you cannot sell and without a seller, and sell hundreds or thousands of con- ownership or delivery obligations are you cannot. As in the baseball analogy, tracts. Traders in the pits of the known as hedgers. A hedger can be an a batter will need a pitcher and a exchanges wear colored jackets or individual, such as a corn farmer, or a pitcher, a batter or their positions have vests designating which brokerage company, such as a corn-chip manufac- no meaning. houses they represent. turer, who buys or sells futures contracts In addition, these team members Brokerage houses actually place the to offset the risk of fluctuating prices in need a ball diamond. In a formal orders to buy and sell future contracts the cash market. When someone is market, that playing field is an or options on behalf of clients—pro- hedging, he is intending to use a exchange. An exchange is a central ducers, elevators, processors or other futures contract as an offset to selling or marketplace where buyers and sellers individuals or companies. The broker- buying the commodity in the cash mar- meet to trade using established rules. age house gets a commission on each ket at a later date. For example, An informal market, such as a farmer’s contract. Everyone who trades - trader if corn prices fall, the corn farmer will market or even a garage sale, allows or broker - must have an account with end up selling his corn at a lower cash for buyers and sellers to make their a brokerage house. price, but realize a gain in the futures transactions on the spot without the A broker, like a trader, must be market by buying a futures contract at a standards and regulations provided registered with the exchange and is lower price than he sold a futures con- by an exchange. responsible for the execution of the tract for originally. If prices happened A futures exchange, also known as a purchase or sale order for his client. to rise, the corn farmer has the higher contract market, has a primary role of A broker isn’t necessarily a floor trader, cash price to cover the loss when he bringing buyers and sellers together. but may work with the trader to con- buys back the futures. This strategy is Each exchange has an established set duct the transaction in the pit or may known as a replacement hedge or a of rules that it enforces to ensure that trade electronically via the Internet, pure hedge. A pure hedge minimizes trading takes place in an open and thereby replacing the open outcry risk and sometimes, but not always, competitive environment. The regula- electronically. earns more than a cash price. tions establish location of trading, trading hours and contract specifications. DID YOU KNOW? A contract is a specified agreement between a buyer and seller that docu- Marketing is so important to industry that about half the costs of goods and ments a transaction. Contracts guarantee that the units being traded are services results from the marketing process versus the actual product, itself. standardized by establishing unit size, Accordingly, more people work in marketing than in production. It’s no quality and delivery timing. secret that the number involved in production agriculture is dropping rapidly, The U.S. government agency that guarantees that standards are adhered also. At the turn of the 1900s, the U.S. had 5.7 million of the 76.1 million to and regulations followed is the people employed in production agriculture. That’s about 7.5% percent of Commodity Futures Trading Commission (CFTC). The CFTC regulates the futures the population. Nowadays, in the U.S., producers account for less than exchanges, brokerage firms, money 1% percent of the total population with just 2.13 million farmers, according managers and commodity advisers. to the 2002 USDA Census. Traders are members of the exchanges and are the ones who buy 6

Module I - What is a Market? (continued)

Another set of integral players that day’s price. The benefits of a cash bushel or per pound on the day of sale. in markets are the speculators. market are that the seller gets cash Although this is an easy transaction for A speculator is not a buyer or seller right away. In addition, because the producers, it is one of the riskiest of a commodity, but rather of contracts. buyer is willing, the transaction is easy marketing strategies as the producer Speculators buy contracts in the hope to complete. In a cash market, the cannot guarantee a price. that they can resell them for a profit. agreement negotiated between the On the other hand, a futures market A speculator is similar to a scalper buyer and seller can be for any quantity has rules and regulations governing its who tries to make a profit by buying that both agree upon and does not transactions, which occur at designated and then quickly reselling at a higher require the payment of commission or exchanges. Contracts determining both price, sometimes only a fraction higher. fees. Commodities or other goods quality and quantity are traded for A scalper doesn’t intend to use the exchange hands in countless locations, delivery, not on the day of sale, but tickets he’s reselling, nor does a spec- such as grain elevators, livestock auc- for a future date. This allows the ulator intend to take physical delivery tions and thousands of other venues, as producer to shift some of his risk as of the commodities underlying the a cash market does not require trades he can lock in his price with a futures contracts he’s trading. to be made at a designated exchange. contract and be protected from possi- Some speculators are day traders In general, cash marketing requires ble falling prices. who buy and sell throughout the trad- less knowledge of the broad market However, the decreased risk isn’t ing day and close their position before beyond the local market. However, without some cost to the producer. the end of trading. Other speculators cash markets pose risks because you Futures contracts require some earnest may be floor brokers, who act as only have one chance to sell and you money up front. This is called the agents for customers and whose role have to take what you get. For exam- margin requirement and allows the may include taking relatively large ple, if you decide to deliver your grain producer to hold the futures contract. positions in the market and holding or livestock to a cash market such as a This margin must be maintained at a those positions over a long period of grain elevator or a packer, you’re obli- certain percentage established by the time. Speculators assume risk in the gated to take what they offer per exchange; if the price of the futures market and provide liquidity. Liquid markets, those with plenty of players with plenty of cash and thus TYPES OF HEDGERS lots of buyers and sellers, are safer Hedger Needs markets for all traders, including producers, because they are easier to Grain farmers They need protection against declining prices enter and exit. Even a ticket scalper for crops still in the field or in storage. cares about a liquid market because They also need protection against rising he doesn’t want to end up with sur- prices of inputs such as fuels. plus tickets. For example, imagine a scalper who had high-priced tickets Livestock producers They need protection against rising prices of for a concert that featured a singer purchased inputs such as feed and against known primarily to the Baby Boomer declining prices of their livestock. generation. If he tried to sell those on Merchandisers/Elevators They need protection against declines in a college campus; he’d probably not prices between the time they purchase or have a liquid market. The number of contract to purchase grain from farmers and those interested in buying tickets the time it is sold. would be few, and because they’re college students, some might not Processors They need protection against increasing raw have the money for the expensive material costs and in some cases against tickets. However, the scalper could declining inventory values. likely find a liquid market selling at a Exporters They need protection against higher prices location frequented by Baby Boomers. for grain they have contracted to deliver in Market Types the future but have not yet purchased. In an informal market, goods or services Importers They want to lock in low prices for grain they are traded on the spot for cash. A cash have contracted to take future delivery of but market allows a seller to make delivery have not yet received. of his goods or services and receive 7

Module I - What is a Market? (continued) contract rises, the producer could face This relatively flat market is known as a SUPPLY CURVE a “margin call” requiring him to put up neutral market. A bullish market is more cash. If the producer holds his one where prices are expected to rise. contract to expiration and then delivers Conversely, a bearish market is one his crop in fulfillment of it, the money where prices are expected to fall. will be returned to him, but in the meantime margin calls can tie up a lot of the producers’ working cash. Establishing a Price In addition, futures markets are more Supply and demand determines the complex and require both buyers and price of a commodity at any given sellers to be knowledgeable about all time. The greater the demand for a aspects of the market and industry in commodity and the less the supply, the order to make smart decisions. higher the price will be. Conversely, the Futures prices fluctuate depending greater the supply and the less the upon many technical and fundamental demand, the lower the price. Supply factors. An understanding of how these and demand are affected by many fac- Point A on the curve shows a lower quantity available because at this lower price, producers provide less factors affect a contract’s price will pay tors and a change in either directly of their commodity. At Point B, you can see that at a dividends. affects market price. higher price, producers make more quantity available. On this chart it is easy to see the direct relationship Supply is the quantity of a commod- price has on supply. Market Trends ity that producers are willing to bring Supply in agricultural markets is No one knows for sure where the to market at a certain price. If prices determined by a variety of factors. market is going, but we do know that are low, a grains producer may decide The season’s projected grain supply is it is going one of three directions: up, not to sell and instead keep the grain determined by adding stocks carried down or sideways. Depending on in storage and wait for a better price. over from the previous year, current whether you are a buyer or a seller, an If milk prices are too low, a producer production and expected production. upwards movement could be positive may decide to cull some of his herd, Since livestock cannot be stored, the or negative; the same is true for a which would reduce the supply of milk downward movement. projected supply of live cattle and as well as the producer’s cost of feed. hogs is based solely on current pro- The trend simply refers to the On the other hand, if prices are high, duction. However, in both crops and general direction in which prices are producers will release greater quanti- livestock the projected production is moving over a period of time. A seller ties into the marketplace. subject to change. wants to know when the market will be at its high so he can sell for the most The Law of Supply is the relationship Crop supply can be influenced posi- money and a buyer wants to know between supply and price. The supply tively or negatively by the weather, when the market will be at its low so he curve (denoted on the graph below with yields, volume in storage, government can buy at the lowest price. Analysts the diagonal line) depicts the direct programs, exports, imports, cost of who follow trends believe two things: relationship between supply and price. production and market price. that prices do follow trends and that once a trend is established, it persists. DID YOU KNOW? A market that is trending up may still have some down days, just as a market Although the first recorded instance of futures trading involved rice in 17th trending down may have some up Century Japan, there is some evidence that there also may have been rice days. If markets go up and down, how futures traded in China as long as 6,000 years ago. do we know what the trend is? An Futures trading is a natural outgrowth of the problem of maintaining a uptrend market is characterized by year-round supply of seasonal products like agricultural crops. In Japan, higher highs and higher lows, whereas merchants stored rice in warehouses for future use. In order to raise cash, a downtrend market is characterized warehouse holders sold receipts against the stored rice. These were known by a series of lower highs and lower lows. A sideways trend simply refers as “rice tickets.” Eventually, such rice tickets became accepted as a kind to a market that isn’t gaining or losing of general commercial currency. Rules came into being to standardize the much over a period of time and is trading in rice tickets. These rules were similar to the current rules of expected to continue just moving American futures trading. along at about the same price levels. 8

Module I - What is a Market? (continued)

Livestock supply varies due to weather, feed, young-stock costs, government DID YOU KNOW? programs, exports, imports and price. The use of the bull and bear as symbols of the market is commonly under- CHANGING SUPPLY stood around the globe. But the origin of the terms is not clear. One of the most common beliefs is that the terms “bull market” and “bear market” were derived from the way the two animals attack—bears swiping their paws downward and the bulls tossing their horns upwards. From the 1500s into the 1800s, bull and bear baiting were popular sports in England. This entertainment involved putting a bear, a bull or both into a pit and letting dogs loose on them to see which animals survived. In this context, “bulls” were understood as the opposite of “bears.” Whether or not it’s true, it’s a useful way to remember what the terms represent. Yet, another common belief is that the term “bear” came from middle-

The graph above details how a positive change in men in the fur trade, who would buy and sell bearskins before the bears had supply shifts the supply curve to the right and a been caught. A proverb known as early as the 1600s advised, “Don’t sell negative change in supply shifts the curves to the left. the bearskins before you’ve caught the bear.” Later the term “bear” was Demand is defined as a quantity of used to describe short sellers, speculators who sell borrowed shares, then a commodity that buyers are willing to buy shares after a price drop and give them back to the person from whom purchase from the market at a given the shares were borrowed. So, bulls being the opposite, bulls became the price. The relationship between term for those people who bought in expectation that the stock prices demand and price is called the Law of would rise, not fall. Demand, which is depicted in the graph below. The “bull” and “bear” terms were explained for what is believed to be the first time in print around 1775 by Englishman Thomas Mortimer in his LAW OF DEMAND book, Every Man His Own Broker, or, A Guide to Exchange Alley. Mortimer’s vivid descriptions of the terms and made them well-known among those in the marketplace. In the 1800s, Harper’s Weekly cartoonist Thomas Nast, played a role in popularizing the bull and bear as symbols of the U.S. stock market. Nast’s work has had a tremendous and lasting impact on American culture. In addition to depicting the market’s bull and bear, Nast also creat- The demand curve on the graph is depicted with the ed the modern images of Santa diagonal line. At Point C, prices are high so buyers are only willing to buy lesser quantities. However, Claus and Uncle Sam, and he even when prices are low, at Point D, buyers are willing to purchase more. introduced the donkey and the ele- phant as symbols of the Just as supply is influenced by a Democratic and Republican parties. variety of factors, so too is demand. Although a clear understanding The season’s projected demand for an agricultural commodity depends on of the origin of the bull and bear consumer preferences, disposable symbols is lost to history, today’s income level, population size and price investors know their meaning and of substitute goods. The Price of relevance. Substitute Goods refers to the price of (The Wall Street Journal Guide to Understanding alternate goods that can replace each Money and Markets by Wurman, Siegel, and other. For example, if the price of beef Morris, 1990.) is too high, consumers may buy pork or 9

Module I - What is a Market? (continued) chicken instead, thereby increasing tors (consumer preferences, income, Consumption is the use of goods or the “white” meat demand. A similar population, and price of substitute services. A high price may cause con- example holds in grains. If the cost of goods). Therefore, the market price sumption to fall; whereas a lower price soy meal rises, producers may substitute influences consumption. may stimulate it. another protein ingredient as a feed- stuff for their animal feeds. DID YOU KNOW? CHANGING DEMAND The 2.13 million U.S. farmers are the most productive in the world. In the 1940s, a farmer could produce enough food and fiber for 19 people for a year. Despite the drop in numbers of farmers from 6.8 million—the largest number ever in the U.S.—in the 1940s, farmers have continued to maximize production, thereby increasing supply. Today a farmer is able to produce enough food and fiber for 144 people for a year, a seven-fold increase in 60 years. However, an increase in domestic output doesn’t solely explain why commodity prices remain relatively low. There are many factors that interplay—government subsidies, foreign competition, consumer prefer-

This graph illustrates how an increase in demand shifts ences and numerous others. the demand curve to the right; a decrease shifts the curve to the left.

MARKET PRICE

This graph illustrates equilibrium price, where the supply curve and the demand curve intersect. When either supply or demand for a commodity changes, the market price will adjust. For example, if demand for wheat remains the same year over year, but supply increases this season due to a high yielding crop, the market price will shift lower. The market price is simply the price at which sellers are willing to sell their products or services and buyers are willing to buy those goods or services. Market price is also known as equilibrium price. The market price is influenced by both supply factors (production, costs, government programs, exports, imports, and price) and by demand fac- 10

Module II - Understanding Market Tools

Introduction to Hedging Strategies DID YOU KNOW? hen discussing marketing, or eBay is one of the best examples of a world-wide market. Founded in price-risk management, the September 1995, eBay touts itself as “The World's Online Marketplace,” Wbottom line is protecting providing a place where a diverse community of individuals and businesses what you receive for your goods or buy and sell goods and services. commodities in the cash market. Because access to the World Wide Web, is universal, buyers and sellers Therefore, the cash price that bidders are brought together from all across the globe. Today, eBay has local sites such as grain elevators offer is very that serve Australia, Austria, Belgium, Canada, China, France, Germany, important. Bidders determine their Hong Kong, India, Ireland, Italy, Malaysia, the Netherlands, New Zealand, cash price by adding or subtracting the Philippines, Singapore, South Korea, Spain, Sweden, Switzerland, their local "basis" from the futures contract price; that basis reflects such fac- Taiwan, the United Kingdom, and the United States. In addition, eBay has a tors as local supply and demand for presence in Latin America. the commodity and freight costs. The eBay community includes more than a hundred million registered The futures contract price is deter- users from around the world looking at millions of items in thousands of mined by traders in the futures market categories, from collectibles like antiques, dolls and baseball cards to through price discovery, the interaction practical items like clothing, books, CDs, electronics and even used cars. of buyers' asking prices and sellers' With the diverse items for sale at any given time, eBay's mission of offering prices in a free marketplace. providing “a global trading platform where practically anyone can trade This interaction will reflect the per- practically anything” seems to be thriving. ceived supply and demand situation With its web interface, eBay has both streamlined and globalized and can be affected by the latest traditional person-to-person trading, which has traditionally been conducted weather forecast, the immediate psy- in more mundane forums, such as garage sales, collectibles shows, flea chology of the market itself, a new diet craze or countless other factors. markets and more. The eBay method facilitates easy exploration for buyers and enables the sellers to immediately list items for sale within minutes of A commodity exchange will typically trade futures contracts for several dif- registering. Traditionally, person-to-person transactions were limited to ferent months each year. For example, people actually being present to see and buy the item for sale, but on the corn contracts are traded on the World Wide Web, the seller has the opportunity for a much larger audience Chicago Board of Trade for December, and the buyer has the opportunity of a much larger selection. March, May, July and September. In this regard, eBay has become an online “middleman” for buyers and Those bidding or offering locally for sellers in a manner in which traditional brick and mortar companies cannot the cash commodity will determine compete. eBay buyers have the option to purchase items in an auction-style which futures contract applies to the format or items can be purchased at a fixed price through a feature called cash market when they will be doing “Buy It Now.” With thousands of items being bought and sold throughout business. For instance, the cash bid the day through the online auctions and fixed prices, eBay is able to analyze may use the "nearby" contract (the contract that will expire the soonest) what the market price is for just about everything. while the forward cash price, or contract price, may use a "deferred" futures contract (one for a later month). The main tools for locking in a cash price are cash sales, cash forward contracting, hedging with futures or buying options. The use of any of these tools transfers price risk to the next level in the system, which must then make the same sort of price-risk management decisions. For example, the 11

Module II - Understanding Market Tools (continued) farmer who sells corn to the local grain price he will receive, it may not be the ward price is enough to cover the pro- elevator, either for cash today or on a best price that was available through ducer's storage and interest costs for forward cash contract, has locked in his the course of the marketing year. old crop. price. The elevator must in turn decide Cash contracting is generally done As mentioned earlier, a forward con- how to protect itself against price fluc- sometime before delivery to lock in tract differs from a futures contract in tuations. In a sense, marketing or price higher prices than what is expected at that the buyer and seller agree on the risk management can be seen as a delivery, or harvest. There are many dif- quantity, the delivery date and other process of price-risk transfer. ferent types of cash contracts, but for specifications, while in a futures con- simplicity this section will focus on the tract the specifications are standard- Cash Transactions three major ones. Those are the ized. In addition, forward-cash con- Forward Contract, the Basis Contract or tracts typically are not traded and don't CASH SALES the Hedge-To-Arrive (HTA) or Futures involve an exchange. When the seller negotiates his sale on First Contract. While a forward contract locks in the the day of delivery, what we have is a FORWARD CONTRACTS seller's forward-cash price and transfers cash sale. Ownership and the price risk price risk to the buyer, the producer of holding the commodity goes to the A forward contract is a cash contract, now assumes production risk - the risk buyer. While the producer knows the but it is negotiated for delivery to take place at a specified later date. The for- of not producing as much of the com- ward contract locks in all components modity as the producer has contracted CASH CONTRACTING of the forward cash price, the deferred to deliver. Advantages futures price and the basis, and thus When the seller delivers the establishes the price the producer will commodity, it will be inspected before • Easy to transact receive upon delivery. Producers tend payment is made and a premium • Immediate payment to sign forward contracts when they or discount may apply if quality or think the market is at seasonally high quantity varies from the forward- • No set quantity prices for new crop, or when the for- contract specifications.

Disadvantages • Maximum risk • Less flexible

FORWARD CONTRACT Advantages

• Easy to understand • Flexible quantity • Locked-in price • Minimize risk • No margin requirements

Disadvantages

• Must deliver in full

• No benefit from better prices

Module II - Understanding Market Tools (continued)

As mentioned, a forward contract get at least $3.15 even if the market decline still further. Those who use a locks in a producer's basis as well as price 60 days from now is much lower. basis contract need to track the the deferred futures price. Basis is deferred futures market for signs of BASIS CONTRACT probably the most often used and least weakening. As with any cash contract, understood word encountered in mar- A basis contract is another method the producer also faces production risk. of forward contracting. As its name keting. Basis is simply the difference If a cash wheat buyer is bidding implies, it involves protecting the between the futures price and the local $2.50 with the nearby futures market at "basis." Basis, you will recall, is the cash market. (Basis = Futures +/- Cash $2.90, for a basis of 40 cents, but is difference between the futures price Price.) It can be either positive or neg- offering $2.50 for delivery in 60 days as discovered on a commodities ative (over or under) depending on the against a deferred futures contract of exchange and the local cash price bid location of the cash market, the local $3.10, for a basis 60 cents, a producer by a particular elevator or feedlot. supply-and-demand situation and the might want to sign a basis contract As basis goes up and down, it is a quality of the commodity. Other factors agreeing to deliver in 60 days for the source of price risk for a producer who that cash dealers must use in setting 60 cents in basis without specifying the has hedged using a futures contract. basis bids are transportation costs and futures price. The producer is expect- It is a not a price risk for one who has profit margins. On any given day, basis ing a seasonal rally in futures prices. If used a forward cash contract, which varies from one location to the next the rally comes and the futures price locks in both the deferred futures price due to local supply and demand, quali- rises, the producer will then lock in the and the basis. ty variations and transportation costs. deferred futures price with the elevator To understand how a forward con- In a basis contract, you lock in basis and a forward contract is established. tract works, consider the following for a future delivery of your commodity Of course, if the futures price weakens wheat scenario. Let's say the local ele- in relation to a specified futures con- instead the producer could be worse vator is bidding $2.90 for wheat while tract but you leave the deferred-month off with the basis contract than if he the nearby futures contract is selling for futures price open for the time being. had signed a full forward contract in $3.40; that means the basis is 50 cents. When the deferred-month futures price the first place. Let's also say the same elevator is moves to an acceptable level, it can be offering a forward-contract price of locked in and a full forward contract HEDGE-TO-ARRIVE (HTA) $3.15 for delivery of wheat 60 days established. Producers use such con- OR FUTURES FIRST CONTRACT from now and the deferred futures tracts when deferred futures prices are A Hedge-to-Arrive (HTA) or Futures price is $3.60, indicating a basis of 45 at what the producer thinks are lows First Contract is the flip side of the cents. The producer may decide that (and thus, the producer has no incen- basis contract. It's a cash contract that he would rather lock in $3.15 and tive to lock the futures price in) while does not lock in all the components agree to deliver grain at the price 60 the basis offered by the elevator for of the forward cash price; the deferred days later. In doing so he gives up the grain delivered in the future is stronger futures price is set while the basis is possibility of getting an even high than normal. A basis contract retains left open to be set before delivery. price should the market rise, in some price risk, that being the possibil- Producers will typically sign such a con- exchange for being sure that he will ity that the deferred futures price will tract during a seasonally strong time in

BASIS CONTRACT

Advantages • Flexible quantity • Minimize risk

Disadvantages

• Must deliver in full • Futures could weaken

Module II - Understanding Market Tools (continued) the marketing year for futures prices. $6.20 ($6.60 -.40) versus the earlier tion that may not take place for several This seasonal strength may not be $5.90 ($6.60 - .70). Of course, if the months into the future. reflected in the basis market as buyers basis weakens instead of strengthens, SHORT HEDGE are unwilling to lock in grain at both a the producer could be worse off than if high futures price and strong basis. had he locked in both basis and futures When a producer plans to sell a commodity at a later date, he can use The HTA or futures-first contract prices in the first place. a short hedge, also known as a selling holds some price risk, that being an hedge. In essence, this works the same adverse change in the basis. Since the Futures Contracts as an HTA or Futures First cash contract basis is left open at the time the con- without the risk of delivery. There's no tract is established, it could weaken as As we mentioned earlier, another way risk of delivery because the producer well as strengthen. Producers need to of hedging is buying or selling futures can always settle his short futures con- keep a close watch on the deferred contracts. Recall that a futures contract tract by buying a corresponding long basis bid and lock it in when it has is a legally-binding agreement to buy futures contract; the sale and the pur- strengthened. Since this is a cash or sell a standardized quantity and chase cancel each other out. The seller contract, the producer also faces quality of a commodity at a later, speci- has once again locked in a deferred production risk. fied date and at a specified location. The only variable with a futures con- futures price (or a nearby futures price As an example of an HTA, assume tract is the price. Hedging using if hedging an immediate cash sale) that a soybean producer needs a price futures contracts is one method of while remaining open on basis. While of $6.00 a bushel to profit on his new guaranteeing the unknown variable- this strategy eliminates production crop and deferred futures have rallied price. Hedging is based on the princi- risk-delivery can be avoided-and price to $6.60. The buyer is willing to for- ple that cash-market and futures-mar- risk, the producer now may face ward contract for new crop delivery at ket prices tend to move up and down margin-requirement risk. In a volatile $5.90, implying a 70-cents under basis. together. The movement, though not market, margin risk could become a The producer, knowing that basis at necessarily identical, is close enough key factor. In addition, the producer harvest is normally 40-cents under (30- that it is possible to lessen the risk in a still has the risk of an adverse move- cents stronger than the current forward cash market by taking a counterbalanc- ment in the basis. contracting price implies), decides to ing position in the futures market. The lock in only the deferred component of losses incurred in one market are offset Short Hedge Example: the contract, the $6.60 deferred futures by the gains in the other market. In price. Then, when the forward-contract On May 6th, near the seasonal peak this strategy, the hedge establishes a basis moves to 40-cents under, the pro- in soybean price tendencies, a soy- price level for a cash market transac- ducer locks basis in, as well. At that bean producer decides to price part point, the producer has a forward con- of his expected production. tract with all components locked in. FUTURES CONTRACTS November soybeans are at $6.00, However, his forward contract price is a level in the upper 25% of historic Advantages price probabilities. The producer has determined • Easy to enter/exit HEDGE-TO-ARRIVE that a cash price of $5.60 per bushel CONTRACT • Minimize risk is profitable and knows that the average basis (difference between Advantages • Often better price than futures price and cash price) at har- forward contract vest is 30 cents under the November • Flexible quantity contract. However, the forward con- • Locked-in price Disadvantages tract price at his delivery point is • No benefit from better prices $5.50, implying a basis of 50 cents • Minimize risk under the November. Expecting Disadvantages • Commission costs basis to strengthen into harvest, the producer would price a portion of • Must deliver in full • Margin calls his expected production by selling • Set quantities November futures at $6.00, leaving • Basis could weaken his basis open. If his expectations at harvest are realized and basis 14

Module II - Understanding Market Tools (continued) strengthens to 30-cents under the The September futures contract Options On November, his net price will be for the next marketing year is trad- Futures Contracts $5.70 ($6.00 - $.30). Another way ing at $2.10, a level in the lower 33% to look at this is through the use of a of historic price probabilities. The OPTION T-Chart (see chart below). feed mill operator has determined Buying options is another marketing LONG HEDGE that a cash price of $2.20 would be alternative that provides a producer A long hedge, or purchasing hedge, profitable. The operator also knows with price protection. In addition, that basis tends to weaken near the is used when you plan to purchase the options allow a producer to benefit end of harvest to an average of zero physical commodity at a later date. from favorable price changes and do (futures and cash price are even). Like the short hedge, the buyer takes not require margin payments. On the Currently, basis is at 15-cents on margin risk, but this time through other hand, the producer pays for this over the December futures contract. the purchase of a futures contract. privilege, the payment being known Again like the short hedge, the buyer is On October 13, the basis the opera- as the options premium, a term we'll open to basis risk but has no risk of tor could lock in drops to 5-cents discuss more thoroughly later. having physical delivery made of the under the December contract as the commodity, because he can settle by local harvest comes in bigger than An option on a futures contract is an selling a futures contract corresponding expected. The feed mill operator agreement that grants a person the to the one he bought. decides to buy the cash corn from right, but not the obligation, to buy or the elevator and sells the futures con- sell a futures contract at a specified tracts to offset the long hedge posi- price before a specified time. In other Long Hedge Example: tion. The net-price paid for cash corn words, you have the right to buy or sell On August 1, near the seasonal low is $2.05, five cents below the expect- a futures contract, but you don't have in corn price tendencies, a feed mill ed purchase price. Another way to to do so; buyers and sellers of futures operator decides to price part of look at this transaction is through the contracts, on the other hand, commit expected needs for the coming year. use of a T-Chart (see chart below). themselves to buy or sell the commodi-

Short Hedge DID YOU KNOW? Futures Basis Cash Net If someone is 'short' or 'long' in May 6 - Sell November futures $6.00 -$0.50 $5.50 the marketplace, it refers to Expected basis and expected net -$0.30 $5.70 whether they are buying or selling a futures contract or a commodity. October 13 - Sell cash at harvest $5.50 -$0.30 $5.20 If you are “short futures,” it and buy back futures means you sold a futures contract. If you make a “short hedge,” you Futures P/L + Cash Sales price sold a futures contract to protect = Net Price Received $0.50 $5.20 $5.70 against a possible lower price before you sell your physical commodity. If you are “short Long Hedge cash,” it means you plan to buy Futures Basis Cash Net a commodity. August 1 - Buy December futures $2.10 $0.15 $2.25 However, if you are “long futures,” it means you have Expected basis and expected net $0.00 $2.10 bought a futures contract. If you make a “long hedge,” you bought October 13 - Buy cash at harvest $2.00 -$0.05 $1.95 a futures contract to protect and sell futures to offset long hedge against a possible price increase before you buy a commodity. Futures P/L + Cash If you are “long cash,” it means = Net Price Paid -$0.10 -$1.95 -$2.05 you plan to sell a commodity.

Module II - Understanding Market Tools (continued) ty at the contract price on the future trading at $2.50, the $2.40 call would $.20 intrinsic value with the balance of date. If the option is not used, it simply be ITM (because it could immediately 10 cents being time value. expires. Each option contract specifies be exercised at a profit by buying the Time value is a variable amount. three things: the right to buy or sell a futures contract at $2.40 and selling it Time value is the amount of money futures contract, the commodity and a second later for $2.50); the $2.50 call buyers are willing to pay for an option commodity month of the contract, and would be ATM, and the $2.60 OTM. in anticipation that the value of the the price at which the futures will be Likewise, the $2.60 put option would option will increase over time due to a bought or sold. be ITM, the $2.50 ATM, and the $2.40 change in the underlying futures price. A "put" option is the right to sell a OTM. This will become important later It reflects the amount of time the futures contract while a "call" option is when strategy is discussed. If the option has until expiration and the the right to buy a futures contract. option's strike range is equal or trader's opinion of the probability that approximately equal to the underlying The option contract coincides with a the option will go off the board ATM or futures contract it is an at-the-money futures contract and therefore its expi- ITM. Volatility is a key factor in time option. (see chart: Options on Futures value, as high volatility raises the prob- ration date is directly tied to the futures Contracts.) ability of the underlying futures moving contract. For example, a September An option doesn't require a margin in a wider range. option expires one to two weeks account as a futures contract does, before the first delivery of the A premium can be high or low, but an option does require a premium. September futures contract. depending upon the comparison of the A premium is the cost incurred to strike price to the current futures price, The designated price of an option purchase a specified options contract. contract is called the strike price. A A premium price is determined in the strike price is the price at which the same manner as a futures price, by the OPTIONS CONTRACT buyer of an option may choose to interaction of buyers and sellers in that exercise the right to purchase or sell market's process of price discovery. Advantages the underlying futures contract. A strike The option's premium is composed • Price protection price does not change throughout the of two different components: intrinsic life of the option contract. The strike value and time value. • Minimize risk price has three categories: "in the The intrinsic value refers to the • Benefit if prices rise money" (ITM), "at the money" (ATM), relationship of the strike price to the and "out of the money" (OTM). These underlying futures-the amount by • Easy to enter/exit classifications refer to the strike price's which the strike price is ITM, ATM or Disadvantages relationship to the underlying futures. OTM. For example, if the underlying An option that is already worthwhile futures were at $5.00 and the premium • Premium cost to exercise--has some value--is called for a soybean $5.20 put option was 30 an in-the-money option and com- cents, the premium would consist of • Requires study mands a higher premium price. $.20 intrinsic value ($5.20 - $5.00) with • Set quantities An option that is not yet worthwhile the remaining 10 cents being time to exercise is an out-of-the-money value. A $4.80 call option selling for a • Commission cost option. For example, if corn futures are premium of 30 cents would also have

OPTIONS ON FUTURES CONTRACTS In-the-money At-the-money Out-of-the-money (has intrinsic value) (has no intrinsic value) Call Option Strike price below the Strike price is equal or Strike price above the underlying futures price approximately equal to underlying futures price underlying futures price

Put Option Strike price above the Strike price below the underlying futures price underlying futures price

Module II - Understanding Market Tools (continued) the length of time until contract expira- later date. Once again, the buyer must Other Methods tion and the volatility of the underlying pay a premium to the seller to obtain futures contract. this right but no margin will be required GOVERNMENT PROGRAMS to hold this position. Owning this posi- The US government supports farmers' PUT OPTION tion establishes a ceiling, or maximum incomes and prices in a vast variety of We mentioned earlier that there are two futures price, the buyer will have to pay ways. In addition to being complicated types of options, a put and call. We'll for a commodity while leaving open the and controversial, most of these discuss a put option first. possibility of a price decrease. government programs lie outside the A put option is a contract that gives the For example, if a feedlot needs to scope of our studies. We will limit buyer the right, but not the obligation lock in corn for feed but doesn't want ourselves here to a brief discussion of to be short the futures market at to pay more than $2.50 for the com- two categories of programs that involve a later date. The buyer must pay a modity, it could buy a $2.30 call for 20- price-risk management: the marketing- premium to the seller to obtain this cents. This establishes the ceiling price assistance loan programs and the gov- right. Unlike a futures contract, buying a at $2.50 ($2.30 + $.20). ernment insurance programs. put option requires no margin money to hold the contract. The maximum money required will be the premium, regardless of the move in the underlying futures market. Owning this type of contract establishes a floor price, or minimum price, while allowing the buyer to take advantage of a price increase. A producer who wants to lock in a price at or above breakeven, but thinks the futures market may continue to go higher, would look at buying a put option. For instance, a corn grower who needs to average $2.00 per bushel on his crop could look at owning a December corn put option with a strike price of $2.30 put option and with a 30-cent premium. By purchasing a $2.30 put option with a premium of 30-cents, the producer has locked in the desired floor price of $2.00. This is accomplished by subtracting the premium (30 cents) from the strike price ($2.30). If the underlying futures market drops to $1.80, the put option premium would be valued at 50-cents ($2.30 - $1.80). If the producer sold his corn at $1.80 and subsequently sold the purchased put option at 50-cents, the net price would be $2.00 ($1.80 + $.50 - $.30 (original purchase price) = $2.00).

CALL OPTION A call option is a contract that gives the buyer the right, but not the obligation to be long the futures market at a 17

Module II - Understanding Market Tools (continued)

COMMODITY LOAN PROGRAM might use in this situation. He could LDP effectively gives the farmer the One of the dilemmas a farmer faces in forfeit his crop to the government marketing loan gain without having to getting good prices arises at harvest. when the loan matures and simply keep take out the loan. The farmer has a crop to sell but so do the loan principal amount. (The loans As you might imagine, this being a all of his neighbors, which means sup- are categorized as non-recourse loans government program, there are rules plies will be large compared to other because the government has no to follow and paperwork to fill out, times of year--and large supplies imply recourse to any other means of pitfalls to avoid and loopholes to low prices. Even if the farmer has an repayment than the crop collateral.) exploit. To take just one example, economical way to store the crop and Alternately, the farmer may purchase limitations on how much any person sell it later when prices have recovered, commodity exchange certificates that may receive from the government there will often be bills to pay that give the right to reclaim commodities affect many but not all parts of the require cash now. at a rate lower than the loan rate, program. The interplay of the regula- Congress created the marketing- allowing the farmer to realize a tions with the farmer's specific circum- assistance loan programs to solve this commodity certificate gain. stances can affect whether it's better problem. For qualifying commodities, Finally, a farmer without a government to take a marketing loan gain, take an which include wheat, corn and soy- loan can also receive benefits through LDP, forfeit the crop or use commodity beans, the government accepts harvest- what is called a loan deficiency exchange certificates. No one should ed crops as collateral for a loan due in payment (LDP). An LDP provides a attempt to play the marketing loan nine months. This loan is made at a one-time, per-bushel (or other unit of game without first boning up on the government-set price per bushel, bale measure) government payment to current rules, which can be obtained or other unit of measure called producers during times of low prices. at the local Farm Service Agency the commodity loan rate, enabling a When the PCP is lower than the loan office or on the FSA section of the farmer to pay bills now while holding rate, the farmer may claim an LDP; the USDA website. his crop and selling it at a later date. The farmer may repay this loan at the DID YOU KNOW? loan rate, plus interest, even if the crop was sold in the market at a higher price. You cannot take a marketing loan before you "harvest" your crop. If, for example, the producer borrows at The government requires the crop to be “mechanically altered” for eligibility a loan rate of $1.95 a bushel, and the for marketing loans or LDPs. The term “mechanically altered” allows the market price at some point rises to program to cover corn silage as it, technically, is not harvested as grain. $2.10 a bushel, the farmer can redeem There are only a limited number of crops that are eligible for LDPs. her loan at $1.95, plus interest, sell for Under the Farm Security and Rural Investment Act of 2002, LDPs were cash at $2.10, and pocket the 15 cents continued from previous law for wheat, corn, grain sorghum, barley, oats, (minus interest) profit. upland cotton, rice, soybeans, and other oilseeds. In addition this Act made Alternately, if a separate government- LDPs newly available for peanuts, wool, mohair, honey, small chickpeas, calculated price, the posted county lentils, and dry beans. LDPs may be made available to producers of unshorn price (PCP) is lower than the loan rate, pelts, hay, and silage, but extra-long staple cotton remains ineligible, under the farmer may repay her loan at this current legislation. lower price. USDA calculates the PCP by Once the marketing loan is taken, you will hear references to “sealing” averaging the cash commodity bids in a the grain. This term came about back when government officials would put particular county (each cash bid is fig- ured by taking the terminal elevator a bright yellow sticker over the bin door signifying that this grain was under price and subtracting shipping and government loan. The sticker detailed the quantity of grain, the date of other transfer costs). The difference loan origination, the owner and the government official that placed the seal. between repaying at the loan rate and The “seal” could not be broken until the farmer notified the government of repaying at the lower PCP is known as a her intentions to sell. marketing loan gain. Even though the yellow seals are no longer utilized, the industry still Let's say the price is deeply refers to the practice of taking a marketing loan as “sealing” the grain. depressed and the farmer sees no Nowadays, the verification of grain quantity is proven through crop prospect of it rising. The loan program insurance and yield records. allows him another alternative that he 18

Module II - Understanding Market Tools (continued)

Long Hedge Example: INSURANCE The policy Coverage Price and pre- Properly informed, the farmer may The government also offers a number miums are set on a daily basis. DTN incorporate the loan programs into of "insurance" programs that allow carries these daily updates. Coverage his or her marketing plan in a num- agricultural producers to protect is calculated from the settlement prices ber of ways: against unfavorable price fluctuations. of selected futures and put options at the Chicago Mercantile Exchange 1. Corn crop harvested, a farmer Crop insurance policies are (CME). Coverage is generally available takes out a government loan at designed for coverage in the event of for policy periods of 13 to 52 weeks. a natural disaster (hail, drought, etc) so $1.95 a bushel, the applicable loan LRP coverage is available in mid- the farmer does not have to assume rate, puts the corn into commercial 2005 for swine, feeder cattle, and fed the financial burden caused by a signif- storage (being careful to maintain cattle in the states of Colorado, Illinois, icant yield loss. Policies are available beneficial ownership) and waits for Indiana, Iowa, Kansas, Michigan, through the government or private the market to appreciate. If the price Minnesota, Missouri, Nebraska, goes down instead, the farmer sells agencies and coverage value is based Nevada, North Dakota, Oklahoma, the grain and pays off the loan at the on historical yield records and current Ohio, South Dakota, Texas, Utah, PCP for her county, say $1.79. The commodity values. Crop insurance is West Virginia, Wisconsin and Wyoming. 16-cent difference is the farmer's required for eligibility in government The Federal Crop Insurance marketing loan gain. farm programs and farm payments, Corporation (FCIC) Board of Directors such as marketing loans. authorized the states for LRP availability. 2. During the planting season, a In addition to protection for grain farmer sells corn futures at $2.35 a farmers, there is also protection for bushel. After harvest, with the crop livestock producers. The details of in on-farm storage, the futures price these programs are extremely compli- declines to $1.85 and the local cash cated and change frequently; what fol- price to $1.80. The farmer buys corn lows is a very general description of futures, closing out the hedge, and the Livestock Risk Protection program, gains 50 cents ($2.35 - $1.85) on the provided to illustrate the general ideas transaction. The crop is still in the only. Anyone actually wanting to use bin. The farmer, not wishing to sell the program should contact the Risk corn at the current low cash price, Management Agency for the most needs protection against a further recent provisions and conditions. decline in the price but assumes a rise in price to be more likely and Livestock Risk Protection (LRP) is an wishes to take advantage of that insurance policy that offers protection increase if it comes. The normal way against a decline in hog, feeder cattle, to do this would be to buy a put or fed cattle prices for the coverage option (the right, but not the period. The program is administered obligation, to sell a commodity in and supported by the Risk the future) at a price above $1.80. Management Agency (RMA) of the But with the loan rate at $1.95, a put United States Department of Agriculture (USDA). option isn't necessary; the loan rate serves the same function, as the Participating producers pay a farmer can always get $1.95 for the premium, just as they would for any grain. Without taking the loan, the other insurance policy. An indemnity is loan rate has served as a price floor, paid to the producer if the cash index the same way a put option does. price of the covered livestock drops Should the market price rise above below a predetermined price, termed the loan rate, the farmer can either the Coverage Price. The Coverage sell the crop for cash at the higher Price is the coverage guarantee or market price or re-hedge by selling a trigger price, and is similar to the futures contract. strike of a put option. 19

Module III - What To Watch For In A Market (The Six Factors)

Traditional Market buyers' and sellers' collective under- But even if he is right about the real- Analysis standing of the world. Some technical world supply-and-demand outlook for analysts are known as "chartists" the commodity, the fundamentalist can rom the studies thus far, you may because they study charts of price still be wrong about where the futures have concluded that protecting movements and compare them with price is going, or at least about when it against unfavorable price fluctua- F historical patterns. Followers of techni- will get there. He may, for example, tions, while important, can also be cal analysis believe price movements ignore the simple weight of money bet- challenging. Mastering futures, options go up and down in more-or-less pre- ting against him in the fundamental and forward cash contracting is just the dictable cycles. debate. In one recent example of this, beginning. To use those tools, a pro- many fundamentalists were sure that the ducer needs to be following the com- TRADITIONAL ANALYSIS FLAWS modities markets and the countless fac- world was awash in soybeans and that Each of these schools has its strengths tors that move markets, factors that future prices would therefore decline. and its devotees--not to mention its interact on so many levels that analyz- What they overlooked was a new group intramural squabbles. Each also has ing markets can seem like playing of players, the so-called "index funds," its flaws. three-dimensional chess at high speed. who were taking money out of the stock Fundamental analysis of necessity market and investing it in long positions But most producers have limited relies on estimates of supply and in commodities as a group. These time to devote to marketing. Even demand. But in a world as large and professional traders need a special lens investors were willing to take losses in complex as ours, we simply cannot be for looking at markets, some sort of soybeans if their commodity invest- certain what the supply and demand system that narrows and simplifies the ments as a class were rising, and their for a commodity will be. factors to be considered. The most patience and tenacity worked to keep common fall into two broad categories: Fundamentalists give great weight soybean prices higher than the funda- fundamental-analysis systems and to the government's monthly statistical mentals seemed to justify. technical-analysis systems. reports, yet everyone knows that in Technical analysts did not make the subsequent months the government same mistake; with their focus on the FUNDAMENTAL ANALYSIS routinely revises its previous estimates, futures market itself they keep track of Fundamental analysis focuses on sup- and the revisions are often sizeable. the "open interest" or number of out- ply and demand. The fundamentalist sifts through weather forecasts, news stories and statistical reports from government agencies and private research firms, attempting to forecast how much of a given commodity the world is likely to have on hand in the future and how much of the same commodity the world is likely to want. In the fundamentalist view, these supply and demand "fundamentals" determine the price at which futures contracts for the commodities will sell.

TECHNICAL ANALYSIS Technical analysis focuses on the price fluctuations of the futures contract itself. Technical analysts are not interested in the real-world supply and demand for the underlying commodity. They assume all of the supply and demand information is already "in the price" because the price reflects 20

Module III - What To Watch For In A Market (continued) standing futures contracts, and this sta- watch in a market to six key factors: nine. To obtain these ratings for the tistic clearly indicated that there was trend, open interest, seasonal index, "trend" factor, we consider both the new money in the market. But technical basis, price probability and volatility. dominant and secondary trends. Each analysis is not perfect. If it were, techni- These six factors combine the best of of the three possible directions of cal analysts would all be rich and fundamental and technical analysis, dominant trend is subdivided into the everyone else would be rushing to taking due note of supply and demand three possible directions of secondary learn technical analysis. fundamentals while at the same time trend. The following grid shows the A key problem is that if cycles exist, "listening" to what the market is trying resulting numerical values for different they are frequently a lot messier and to say. Six Factors analysis avoids price combinations of dominant and second- harder to decipher than you might prediction, concentrating instead on ary trends. think if you simply accept the technical- the strategy best suited to a particular analysis premise that history repeats market. UPTREND itself. Even Mark Twain's refinement on the premise-"History doesn't repeat TREND itself, but it does rhyme"-may make the The analysis of any market must begin interpretation of charts sound simpler with trend. Simply put, trend is the than it is. Figuring out how and where direction of the market--which way history rhymes amid all the false starts prices are moving. Of course, prices and wayward turns of the chart lines is seldom move in a straight line; they the chartist's art-and it is an art, not a often go up one day and down the science. The technical analyst has lots next, in a sort of peaks-and-valleys for- of ways of his own to get it wrong. mation. So to be more precise, trend is Finally, both fundamental analysis the direction of the peaks and valleys. and technical analysis share two flaws In these charts the vertical axis is in common. Practitioners of each system, price, the horizontal axis time. or at least some of them, try to predict Depending on the measure of time DOWNTREND futures prices. But Chaos theory teach- used on the horizontal axis, what we're es that prices cannot be predicted: examining could be the long-term A butterfly flapping its wings in Beijing trend, the intermediate-term trend can cause a hurricane eight months or the short-term trend. A long-term later in Boca Raton; a cow eating bad trend is price direction extending from feed in Alberta can cause a scare over six-months to many years.Intermediate- "mad cow disease" in Alabama eight term trends can be classified as those years later. Neither fundamental nor in existence for one to six months. technical analysis has any way of fore- Short-term trends reflect price direction seeing the consequences of Chaos. from a number of days up to three to Both systems also require their four weeks. respective devotees to deal with too For many agricultural commodities, much information. To use either funda- the most important trend to watch, mental or technical analysis with any what we call the dominant trend, is the confidence, you are quickly back to intermediate-term trend. The next SIDEWAYS TREND three-dimensional chess at high speed. most important or secondary trend is the short-term trend. This reflects the seasonal cycles of most crops, which Introduction To DTN's tend to cover at most several months, Six Factors Analysis and the short-term psychology of agri- However, in this module, we are going cultural-commodity investing. to teach you a much simpler way than What do we do with our trend the methods just described. It is called observations? For each of DTN's Six DTN's Six Factors, and as the name Factors, our analysis produces a set of implies it reduces what you have to numerical ratings between one and 21

Module III - What To Watch For In A Market (continued)

As the table below suggests, a mar- slight pause in the selling that has that logic would dictate (if the supply is ket with both a dominant uptrend and taken prices lower, but not necessarily increasing, the price would tend to secondary uptrend would rate a nine. a change in the longer-term trend. decline, other things being equal), so A nine means prices have been rising Trend is first and foremost a techni- in this case we would say the funda- and seem poised to continue to rise. cal analyst's tool, but at DTN we also mental signal loosely confirms the tech- A market with a dominant uptrend and check whether fundamental supply- nical signal. secondary downtrend would rate a and-demand drivers confirm or conflict seven. A seven is an uptrend, but with the technical signals. For soy- OPEN INTEREST one that may be in a period of price beans, we watch USDA's world ending In commodity markets, open interest consolidation or even in the process stocks-to-use ratio. In the chart below, is the total number of outstanding of changing direction. we see world ending stocks of soy- contracts held by traders at the end of Conversely, a market that has been beans rising as prices of soybean a trading session. It is the number of trending lower over many months but futures fall. Later, with futures prices outstanding long or short positions, has seen a short term rally would be turning upward, world ending stocks but not the sum of the two, for it takes rated a three. This would indicate a begin to fall. This is the relationship both a long and a short position to establish a trading contract. DOMINANT AND SECONDARY A buyer of a futures contract is said to hold a "long" position, while a seller TREND COMBINATIONS is said to be "short." 9 Secondary Uptrend Open-interest statistics help us Dominant 8 Secondary Sideways trend gauge the intentions of key market players: Are they bullish or bearish? Uptrend 7 Secondary Downtrend Have they been buying recently, or 6 Secondary Uptrend selling? Analyzed in tandem with other statistics, the open-interest numbers Dominant 5 Secondary Sideways trend can provide clues to the market's Sideways trend 4 Secondary Downtrend future direction.

3 Secondary Uptrend Exchanges release some open-interest numbers at the end of each trading Dominant 2 Secondary Sideways trend day. The Commodity Futures Trading Downtrend 1 Secondary Downtrend Commission releases a more complete report every Friday giving positions

Module III - What To Watch For In A Market (continued) and activity as of the previous Tuesday. hold contracts as hedges, but even if long position for every short position in The CFTC statistics are used in reckoning they're speculators they're more likely to the market as a whole, one category of DTN's Six Factors. be trend followers than trend leaders.) market player can and often will be net We focus on the positions of the As the following table (Soybean long or net short.) so-called large non-commercial traders, CFTC) suggests, the open interest of The large non-commercials' activity who for the most part are speculators. large non-commercials has proven to shows whether they were net buyers in They're the traders most likely to move have a direct correlation with futures the previous week, net sellers or neu- the market by shifting significant sums prices. The positive numbers above tral. The interaction of the three possi- of money into and out of commodities. zero on the left vertical axis indicate ble positions with the three possible (Another group of traders, the com- long positions or bullishness; the minus activities produces the nine-point grid. numbers below zero indicate short mercials, often collectively hold more Let's now look at an abbreviated positions or bearishness. contracts than the large non-commercials, version of a CFTC open-interest but they're less likely to make frequent In analyzing the large non-commer- report and see how we assign our trades because their positions are cials' open interest, DTN looks at both one-to-nine ratings. This is the report typically hedges against cash-market their positions and their activity. Their for soybeans traded on the Chicago holdings. A third category, non- positions show whether they were net Board of Trade as of Tuesday April 5, reportable traders, is also unlikely to long in the previous week, net short or 2005. We're viewing only that section move markets. They're small, they may neutral. (While there is a countervailing of the report dealing with large non- commercials; the full report would also cover the commercial and non-reportable categories. Under "commitments" the report shows the large non-commercials holding a net long position of 8,671 contracts (52,451 long minus 43,780 short). Spreads (holdings of both a long position and a countervailing short position) are not a factor in this equation. Under "changes" the report indicates the large non-commercials reduced their long positions by 5,752 contracts and also reduced their short positions by 306 contracts, for a net reduction of the previous week's long position of 5,446 contracts.

OPTIONS ON FUTURES CONTRACTS Long Positions Short Positions Spreads Commitments (Number of contracts 52,451 43,780 24,332 of 5,000 bushels per contract as of 04/05/05)

Changes Changes (In number of contracts held from 03/29/05 to 04/05/05) -5,752 -306 1,495

Module III - What To Watch For In A Market (continued)

In short, the speculators were net them weekly net buyers. This combina- mental supply and demand issues that long soybeans but also net sellers. This tion would be rated a three and would arise from a commodity's seasonal pat- would result in an open-interest rating be an indicator of a possible change tern. For example, during the planting of seven on DTN's grid. in opinion on the part of the non- season farmers are busy in the fields A seven would indicate that non- commercial trader. and have little time to market stored commercial traders continue to hold a grain. As a result, buyers who need long position, but either some of their SEASONAL INDEX grain have to raise their bids. Other bullishness is beginning to wane or the The seasonal index looks at how things being equal, agricultural market has slipped into a price consoli- commodity prices have risen and fallen commodity prices will tend to rise dation pattern. during the comparable week and during planting season. This second example uses the CFTC month of earlier years as a guide to Of course, other things are never for Chicago wheat from September 16, what they might do during the same precisely equal, which is why the repe- 2005. It shows non-commercial traders week and month this year. It is a factor tition or rhyming of history is at best holding a large net-short (short posi- both fundamental and technical ana- irregular. One question analysts wrestle tions less long positions) futures posi- lysts can love: On the one hand, it is with is which history to look at. In many tion of 40,754 contracts. However, they based on the technical notion that market commentaries you will see added more long positions and got out history repeats itself, if only irregularly; references to comparable past years: of some of the short positions, making on the other hand, it reflects the funda- "This year is just like 1988," the commentator might say. Citing a similarity DTN GRID in the weather or in demand trends or whatever; the commentator will then Large 9 Weekly net buyers go on to argue that we can expect Non-commercial 8 Weekly net neutral this year's prices to behave as prices did in 1988. holding net-long 7 Weekly net sellers but still long But no year is exactly like any previ- 6 Previous week short, now net-long ous year in every respect. This year may resemble 1988 if weather is the Neutral 5 Neutral criterion but the two years may be 4 Previous week long, now net-short very different in some other respect that's more important--and there are Large 3 Weekly net buyers but still short so many possible criteria for comparing Non-commercial 2 Weekly net neutral years that the commentator's chances holding net-short 1 Weekly net sellers of overlooking the most important one and thus being wrong are high. If Rating 7 nothing else, the search for comparable years takes us right back to a place we

OPTIONS ON FUTURES CONTRACTS Long Positions Short Positions Spreads Commitments (Number of contracts 48,679 89,433 26,204 of 5,000 bushels per contract as of 09/13/05)

Changes Changes (In number of contracts held from 09/6/05 to 09/13/05) 4,271 -1,629 6,355

Module III - What To Watch For In A Market (continued) don't want to be, playing high-speed predict prices, an average should be So using Kansas City wheat for the three-dimensional chess. good enough. five years from 2000 to 2004, we calcu- A better approach is to use the Constructing a seasonal index starts late that the five-year average long-term average seasonal price with collecting the average monthly September price is $3.41 a bushel. movement as the reference point. prices for the commodity over a period The average price for all 12 months is Granted, this year is no more likely to of years; we've used five in the exam- $3.32 a bushel. September's $3.41 is duplicate the average than it is to ple below. Then, for each month, we thus about 3 percent higher than the $3.32 average, so the September index duplicate any particular supposedly calculate a five-year average price. is 103 percent. similar year. But if you're viewing the Finally, we compute an average of the seasonal comparison in tandem with 12 months' five-year average prices, Charting our data underscores the other factors to get a rough idea of against which we can compare any par- seasonal cycles that prices follow. The market trends, as we are, rather than to ticular month. chart (5-year July Kansas City Wheat

5-YEAR JULY KANSAS CITY WHEAT SEASONAL INDEX Index Mo. Avg. 2004 2003 2002 2001 2000 JULY 100% $3.31 $3.29 $3.40 $3.45 $3.24 $3.18 AUGUST 103% 3.41 3.43 3.63 3.37 3.25 3.35 SEPTEMBER 103% 3.41 3.35 3.81 3.23 3.33 3.32 OCTOBER 101% 3.35 3.39 3.75 3.10 3.40 3.13 NOVEMBER 101% 3.36 3.63 3.60 3.07 3.42 3.07 DECEMBER 99% 3.28 3.70 3.39 2.98 3.39 2.93 JANUARY 101% 3.36 3.90 3.31 3.02 3.48 3.07 FEBRUARY 100% 3.32 3.86 3.37 2.96 3.31 3.11 MARCH 98% 3.26 3.95 3.17 2.92 3.28 2.98 APRIL 98% 3.25 4.09 3.06 2.93 3.26 2.90 MAY 99% 3.28 3.98 3.29 2.85 3.27 3.00 JUNE 97% 3.22 3.77 3.14 3.09 3.09 3.02 Yearly Average 3.32

Module III - What To Watch For In A Market (continued)

Seasonal Index), for example, makes confidence to place in the seasonal average prices for each week of the clear that while Kansas City wheat index in a particular year. As the next year over the same five-year period. typically fetches a higher-than-average chart indicates, for the first six months The monthly and weekly indices price in September, there is no of 2005, the July Kansas City wheat each have three possible directions: seasonal reason to expect an increase contract followed the seasonal pat- up, down and sideways. This makes from August to September; the aver- tern fairly closely. possible nine different possible combi- age price and index number is the Rating the seasonal index on DTN's nations. same for both months. nine-point scale requires looking at As an example, a monthly index that Then, by plotting this year's aver- indices for both monthly and weekly shows a seasonal tendency to move age monthly prices on the same chart average prices. For simplicity's sake we with the seasonal index, we can get a have only shown a monthly index in DID YOU KNOW? sense of how well the current year is our Kansas City wheat example, but tracking the five-year average. This in obviously a similar exercise could be Futures prices are typically quoted turn will give us a sense for how much done to create a weekly index using in four digits without a decimal point, the fourth digit representing DTN GRID an eighth of a cent. So on a futures quote screen, like the ones Monthly 9 Weekly seasonal uptrend in DTN's market sections, the Seasonal 8 Weekly seasonal sideways trend September average that we cite Uptrend 7 Weekly seasonal downtrend above as $3.41 might have appeared as 3412, which a trader Monthly 6 Weekly seasonal uptrend would read as "three forty one Seasonal 5 Weekly seasonal sideways trend and a quarter," since two-eighths Sideways trend 4 Weekly seasonal downtrend equals a quarter. In the Seasonal Monthly 3 Weekly seasonal uptrend Wheat Index table (p.26), we Seasonal 2 Weekly seasonal sideways trend dropped the final digit in the table and reconverted the quotes to Downtrend 1 Weekly seasonal downtrend dollars and cents for ease of Rating 6 understanding.

Module III - What To Watch For In A Market (continued) sideways combined with a weekly number, depending on local supply, Basis, like futures prices, has seasonal index indicating a tendency to work demand and cost considerations, and tendencies. But as with futures, changes higher would be rated a six. A six can strengthen or weaken from time to in supply and demand can cause a might describe a market that tends to time as those considerations change. deviation from the seasonal norm. A trade higher but is currently in a con- Basis is said to strengthen if it's getting drought that reduces the corn crop may solidation pattern. less negative or more positive; it is said boost the futures price of corn and On the other hand, a market that to weaken if it's getting more negative strengthen the basis contrary to season- has a longer-term tendency of trading or less positive. Thus, if basis is -30 one al tendencies; the next year, assuming higher but a short-term tendency to week and -25 the next, it is strengthen- the weather has returned to a more trade lower would receive a rating of ing; if it is 28 one week and 23 the normal pattern, price and basis will likely seven. This would indicate that on next, it is weakening. revert to more normal historic patterns. average, the short-term drop in price does not last and could constitute a Standard deviation, normal distribution buying opportunity for someone in need of the product.

BASIS Basis, the difference between the futures price of a commodity and the cash price, is the key fundamental factor. It reflects the "real" supply-and- demand situation, as opposed to the "known" or perceived situation reflected in government and private estimates of crop yields, acreage, usage and inventories. Basis can be a positive or negative

Module III - What To Watch For In A Market (continued)

The following chart reveals one of Because there was no comparable For example, assume during a the uses of basis. The gap between the new demand for cash corn, the gap given week that corn has a seasonal top two lines is the historical basis, as between cash and futures--or basis-- basis level of -2 1/2 cents (that is, cash the top line charts the two-year aver- widened. corn's price is 2 1/2 cents under the age futures prices and the bottom the futures contract) and that 68% of the To rate basis as a factor on DTN's two-year average cash prices, as com- spreads between current and historic nine-point scale, we first determine puted by DTN (DTN used national basis over the last 10 years fell within 6 whether the difference between current average cash prices, but could have 1/2 cents of the mean, making 6 1/2 and historical basis is strong, weak or done a similar chart using any individ- cents equal to one standard deviation. If ual grain elevator's cash prices). The neutral. We then determine whether the the current basis market is -10 (cash corn difference between the bottom two seasonal basis is strengthening, weaken- is 10 cents under the futures), the current lines is corn basis so far this year. Note ing or neutral. These two determina- basis would be -7 1/2 cents weaker than that while this year's basis tracks the tions can interact in nine possible ways. the seasonal basis, which is greater than seasonal pattern fairly well, it is signifi- To make the first determination the 6 1/2 cents single standard devia- cantly weaker or more negative than requires a mathematical tool called the tion. So using the following grid, we the historical basis; the gap between standard deviation. Basically a standard would categorize basis as weak. the two lines is wider. deviation is a measure of how spread The second determination is made Why might that be? The traditional out a set of numbers is. In a normal by simply looking at the seasonal basis explanation for a phenomenon like this distribution, 68 percent of the numbers chart. If, historically, the next move of basis is to strengthen, we have a would be that corn supplies are ample; are within one standard deviation from strengthening basis. A combination of cash buyers are able to obtain all the the mean (34 percent on the plus side a weak basis with a strengthening basis corn they need without bidding higher. and 34 percent on the minus) and 95 would rate a three on DTN's scale. This is what we meant when we said percent of the numbers are within two earlier that basis is the "real" supply- standard deviations. A three for basis tells us the funda- and-demand factor, and in this case mentals are bearish but there's a Using historic seasonal basis as the government estimates of the known or chance of a turnaround in the not-too- mean, our neutral basis is when sea- perceived fundamentals supported the distant future. Another example would sonal basis and current basis are equal notion of abundant corn. In 2005, there be the hard red spring wheat market of or within one standard deviation. was potentially a second explanation for 2005. Basis levels were much stronger Strong basis is when the current basis the gap, as well: demand for corn than normal and continued to hold this is more than one standard deviation futures was inflated throughout the first strength until harvest was set to begin. stronger than the seasonal basis; weak few months of the year beyond what it For many weeks, this type of basis basis is when the current basis is more would have been otherwise by the influx strength rated a nine and indicated a than one standard deviation weaker. of "index fund" money mentioned in strong commercial market existed. the overview. In economists' jargon, the entire demand curve shifted to the right; DTN GRID there was increase in demand for the Strong Basis 9 Basis seasonally strengthening futures at every price level. Greater than 8 Basis seasonally neutral DEMAND CURVE SHIFT TO RIGHT 1 standard deviation 7 Basis seasonally weakening

Neutral basis 6 Basis seasonally strengthening Between 1 and (-1) 5 Basis seasonally neutral Standard deviations 4 Basis seasonally weakening

Weak Basis 3 Basis seasonally strengthening Greater than 2 Basis seasonally neutral -1 standard deviation 1 Basis seasonally weakening

Rating 3 (P=Price, Q=Quantity, S=Supply, D=Demand) 28

Module III - What To Watch For In A Market (continued)

PRICE PROBABILITY equals the current futures price are "at wider the trading range, the higher the Price probability looks at historical the money." Those that could only be probability that the particular option will price trends to help us determine the exercised at a loss are "out of the trade at or in the money before expira- likelihood of price increases or decreas- money." tion. As this probability increases, so es in a particular market. It is defined as An option's premium is the sum of does the value that the market places the percent of the time a commodity its intrinsic value and its time value. on the time left before expiration. has historically traded over a given The intrinsic value is the extent to DTN's rating system breaks volatility price level. A market with a price prob- which they are in the money. The time down into three categories; high, neu- ability of 10% would indicate that the value reflects how much time is left tral, and low. The formula for calculat- market only trades above the current before the market expires and the mar- ing volatility is too complex for this dis- level 10% of the time; the other 90% of ket's perception of the chances the cussion. Suffice it to say that markets the time it has traded below that level. option will gain intrinsic value during with high option volatilities (27% or An old maxim urges agricultural pro- the remaining time. higher) would be considered over- ducers to sell in the top third of the Volatility can be defined as a one- priced and generally have better sell- market. In this chart the top third price standard-deviation price change, in per- ing opportunities than buying opportu- range for live cattle is above $77.50 cent, for a certain period of time. The nities. Markets with low option volatili- per hundredweight, the bottom third is higher the volatility of the option, the ties (24% or lower) would be consid- below $71 per hundredweight and the wider the trading range is expected to ered under-priced, with better buying current price, $90, is in the top five be over that set period of time. The opportunities. percent of historical price probabilities. To rate price probability as a DTN factor, we look at each third of the market and then subdivide the thirds into thirds. Our $90 current price, falling in the top third of the historic upper third, would rate a nine. Clearly, at this level the market has very little likelihood of rallying further but plenty of room to fall. Taken on its own or in tandem with other factors, a nine market is telling the producer to sell, lock in or at least protect the current price. Conversely, the 2005 canola market spent a considerable amount of time in DTN GRID the lower 15% of its historic price prob- Historic 9 Historic 1%-11% price probability abilities and rated a two. This provided end-users, or buyers, ample opportuni- Upper 8 Historic 12%-22% price probability ties to secure needed supplies at his- Third 7 Historic 23%-33% price probability torically low prices. Historic 6 Historic 34%-44% price probability VOLATILITY Middle 5 Historic 45%-55% price probability Options volatility, a measure of the Third 4 Historic 56%-66% price probability speed of the market, helps us focus on proper market strategies by giving us Historic 3 Historic 67%-77% price probability insights into how expensive options Lower 2 Historic 78%-88% price probability premiums are. Third 1 Historic 89%-99% price probability Options that can be exercised immediately at a profit are "in the Rating 9 money." Those whose strike price 29

Module III - What To Watch For In A Market (continued)

A market with 20 percent option when you sell a futures contract, you the exchange until the contract is set- volatility would rate a one. Volatility commit yourself to selling a commodity tled. If the price of a commodity that a this low would usually indicate a period at a specified price at a future date; as producer is short rises, the producer of price consolidation or major turn a producer of the commodity, you are will receive "margin calls"--demands coming. As low volatility indicates pre- said to be short hedged, having for still more collateral--that can miums could be under-priced, a market "locked in" your price (if the cash price squeeze his cash reserves. But in this rated one might be a good time for goes down and you get less for your case, given the high price probability, employing options as part of a market- product at the grain elevator or feed- there would seem to be relatively little ing strategy. lot, your profit on the futures contract room for the price to rise, so the risk of Another example occurs most often offsets that loss, whereas if the price being pressured by margin calls is low. in markets driven by weather changes rises and you make more in the cash Buying a put option would also lock with high volatility. Ratings can easily market, your cash profit is offset by in the price. Recall that buying a put be 30% or higher, earning a nine on your loss on the future contract). Aside option gives you the right, but not the this scale. In markets such as this, from the broker's commission, the obligation, to sell at a given price at a option premiums are over-priced. expense and risk in short futures lies in future date; it the cash price rises, you'll However, depending on what the other the margin requirement, the earnest- let the option expire unexercised and factors are indicating, these over-priced money collateral that must be left with take your cash-market profit. So a put options may still be the best strategy for the type of market that exists. DTN GRID SIX FACTOR SUMMARY 9 29% volatility and higher Let's say that we calculate our six fac- High Volatility 8 28% volatility tors for a given commodity and end up 7 27% volatility with a set of ratings that look like the chart below: 6 26% volatility What kind of a market is this? And Neutral Volatility 5 25% volatility what should a trader do about it? 4 24% volatility This would be a market that has been trending upward but may now be 3 23% volatility in a consolidation phase. You can see Low Volatility 2 22% volatility that in the trend, which shows a long- 1 21% volatility and lower term uptrend while the short-term trend is down. You can also see it in Rating 1 the open interest, where large non- commercials are still net long but have been selling in the last week. True, the seasonal pattern might suggest an SIX FACTOR CALCULATIONS increase in the coming week, but with Factor Rating Combination prices in the top 11 percent of the probability range, any rally is likely to Trend 7 dominant uptrend, secondary downtrend be small. Basis is historically weak, possibly due to large supplies, but is Open Interest 7 holding net long, weekly net sellers strengthening in the short term. Seasonality 6 monthly sideways, weekly uptrend For a producer of the commodity, the proper strategy would be to lock in Basis 3 weak basis, seasonally strengthening the high price. Selling a futures contract, also referred to taking a short Price Probability 9 historic upper third, 1 percent to 11 percent probability futures position, would achieve this with relatively little expense and an Volatility 1 low volatility, 21 percent or lower acceptable level of risk. Recall that 30

Module III - What To Watch For In A Market (continued) option allows the producer to enjoy any upside in the price, in addition to protecting against downturns, and with options there are no margin calls. But the buyer must pay the options premium and that's money that the producer will never get back, unlike his margin money; the buyer pays it in hopes that his profit will be greater than the premium. The problem here is that with prices already in the top 11 percent, the potential for a highly profitable further climb in prices is small. On the other hand, with volatility rated one, 21 percent or lower, the options premium should be relatively inexpensive. Each strategy has its pluses and minuses in this situation. Selling futures would appear to be the first choice unless one is unable to tolerate possible margin risk. Then, the put option strategy would be advisable knowing full well that the buyer of the option is giving up a portion of his sales price in premium costs. Selling in the cash market would not be a good strategy at this time because basis is weak. The producer should lock in the favorable price using futures or options and only sell for cash when basis has strengthened.

Module III - What To Watch For In A Market (continued)

EXAMPLE 1 Market players don't have to do their Grains and Newsom's Quick Takes) and Understanding DTN's Six Factors will own Six Factor ratings and analysis, in his weekly column, Newsom on the give a hedger a big edge in under- however; DTN's senior analyst does that Market. To give you further insight into standing the type of market currently for them in his daily market commen- how the Six Factors work in practice, we faced and the strategies to consider. taries (Before the Bell Grains, Closing have reprinted two columns here.

NEWSOM ON THE MARKET - To begin with, both the intermediate (one-month to six- 08/17/05 month) trend remains sideways. Despite the short-lived

Autumn is just around the corner, bringing with it one of rally to $2.63, front-month contracts remain in a range the most anticipated corn harvests since....well, last year. between $2.35 and $1.91. The September contract is test- ing light support near $2.09, but giving all appearances Last year at this time, expectations were for yields to that it is headed back toward $2.00. average almost 149 bushels per acre (bpa) as compared to this year's projected 139 bushels per acre. When all was Fundamentally, this indicates the market isn't overly said and done, the 2004/05 corn yield would average 160 concerned with production problems at this point. The bpa nationwide, a record eclipsing the 142 bpa mark set market should continue to grind lower in dull activity until in 2003/04. That's just one of the things that make this actual yield reports start coming in. coming harvest so interesting. Non-commercial traders continue to hold net-long

Despite all the problems this crop has faced, most futures positions (as of the August 12 CFTC report), but notably one of the driest April through July growing peri- are liquidating a portion with each passing week. This ods on record in Illinois, USDA's projection of 139 bpa would imply that corn, at least for the time being, has lost would make it the third highest yielding crop on record. some of its luster as an investment opportunity as the key However, the 139 bpa is not set in stone. In its August reproductive month of July passed into history. report, USDA used an average Illinois yield of 125 bpa. Seasonally the market tends to work lower from now While well below last year's historic 180 bpa, many through early October. This is known as the harvest low as believe this is still overstated. available supplies increase.

DTN's man-on-the-floor Gary Wilhelmi said that talk on Basis is an interesting factor this year. Using the DTN the floor following the report was that the Illinois yield was National Corn Index chart, the average U.S. basis can be probably closer to 100 bpa than 125. If this is accurate calculated at 33 1/2 cents under the September contract. and all other states yield as expected, the U.S. yield would Normally at this time of year basis is approximately 10 to drop to 135 bpa, the sixth largest on record. This would 15 cents under the September. This indicates the markets' imply total production of 10 billion bushels and U.S. end- belief that old-crop supplies remain burdensome. In its ing stocks of about 1.6 billion bushels. August report, USDA projected 2004-2005 ending stocks

These are all nice numbers, but illustrate only a large at 2.11 billion bushels. It is a generally accepted principle amount of "what-if's" and "could-be's". In lieu of that, of the market that anything over 2 bb is considered ample let's take a look at the few key market factors that we stocks to start the next marketing year. know now. These are the DTN Six Factors that have been Seasonally, though, basis tends to weaken further as discussed before. harvest progresses. However, if yield does start to show

Module III - What To Watch For In A Market (continued)

signs that more damage was done than projected, the futures contract and establish a synthetic put. Of the two, seasonal low in basis could be occurring now. Looking at the LDP makes more sense as it removes margin risk and the carry (difference between the front-month contract and doesn't require option premium to be paid.

deferred contracts) in the market, commercial traders If a producer has cash-contracted new-crop corn, a cou- aren't tipping their hand yet. The March contract is about ple of alternatives also exist. Call options could be pur- 10 cents over the December, roughly 60 percent of full chased (due to the low volatility), establishing the equiva- commercial carry (commercial storage plus interest). lent of a cash minimum price contract (cash contract less If commercial traders were convinced that supplies option premium).

weren't going to tighten this marketing year, this spread Another possibility would be to buy Corn Index futures could possibly be out to near 80 percent of full commercial as an offset to the established cash contract. If the market carry, or 13 1/4 cents. It may yet work toward that level, continues to go lower, gains in the LDP will offset losses in but more will need to be known about production first. the Index futures. On the other hand, if the market does Historic price probability is also an interesting factor. rally to higher probability levels, gains realized on the Compared to the overall corn futures 5-year price proba- Index futures could be added to the cash contracted bility, the December contract is still in the upper 50 per- price. Another feature of the Index futures is that if basis is cent. However, if compared to the 5-year price probability near harvest lows, basis appreciation will be realized in the of December corn futures only, the 2005 contract is in the Index futures. One drawback to this strategy is the low lower 10 percent. This would indicate that the market open interest in the Index futures. While the lack of liquidi- may not work much lower, possibly due to less than ty may make them difficult to trade, it shouldn't preclude expected yields. a producer from using them.

Volatility has also dropped dramatically. The implied As autumn nears, it is obvious that there is more to volatility of the Dec. contract is now at 22 percent. think about than the fortunes of the local football team. Volatility at 21 percent or less is considered low, with 29 However, breaking it down to its simplest factors makes percent or above considered high. the process much easier. At this busy time of year, with

Combining these six factors will lead to a strategy con- school getting under way and many preparing for harvest, clusion. At this time, it is best to remain protected against the easier other decisions become the better. the non-commercial selling and the seasonal tendency to work lower. However, with prices near the low end of the Commodity trading is very complicated and the risk of loss is substantial. The author does not engage in any commodity trading activity for his trending range, such low probability of working lower own account or for others. Neither the author nor DTN make any repre- (December contract only), and low implied volatility, some sentations or warranty as to the accuracy or fitness for any purpose or use form of put strategy would seem appropriate. of the information contained in the article. The author and DTN are not This could be done a number of ways. If a producer is liable for any direct, indirect, or consequential loss arising from any use of or reliance on the information contained in this article. Neither the author holding a short futures hedge -- has previously sold of this article or DTN is a registered Commodity Trading Adviser. The infor- futures to lock in a price -- he could buy the short futures mation provided is general, and is NOT a substitute for your own inde- back (offset) and be covered by the LDP (the equivalent of pendent business judgment or the advice of a registered Commodity a put). Or, he could buy a call option to offset the short Trading Adviser. Use this information at your own risk.

Module III - What To Watch For In A Market (continued)

NEWSOM ON THE MARKET - And then there is wheat. With all of its different classes, HARVEST PRICING grades, and qualities, it is a complex market. I have long 07/06/05 held that of all the markets, wheat can make one look the If I were to mention the names Stuart Sutcliffe, Roger most foolish.

Federer, and Jack Kilby, most people wouldn't know who I On the futures side, wheat has a few personality quirks was talking about. Such is the case with wheat. While corn that set traps for unknowing market participants. For and soybeans get most of the press, this often-ignored crop example, a favorite of the Kansas City market is the spike still reigns as one of the most important markets in the world. bottom or top. This is where a contract will quickly move The simple truth is people like to eat. In most cases, it through a support or resistance level, just enough to trig- is considered a necessity. And since man first grabbed a ger stop orders, and then move back the other way with handful of wheat, smashed it with a stone, and baked it the newly initiated trade losing money.

over a fire, bread has been a staple of life. With that in mind, let's use DTN's Six Factors to analyze Let's be honest, outside of the occasional anti-carb what the wheat market has to say about itself, and there- dieter, who doesn't like the smell of fresh baked bread? fore what strategies may be best suited for the individual Walking in the vicinity of a bakery in the morning, it's not markets.

the pastries and cakes in the window that set one's mouth To begin with, study the three Index charts (HRW, SRW, to watering, but the smell of fresh-baked bread in the air. and HRS) found on your DTN Online. These will show that John Hiss is a good friend of mine from Great Bend, the general trend -- price direction -- of the three markets Kansas. He once gave me a price chart titled, "The Greatest appears to be in the early stages of an uptrend. This fits in Market of Them All". It's a price history dating back 500 with the seasonal tendency (3-year average) of the differ- years or so of wheat. I had it hanging on the wall of my ent markets to work higher into the early fall. office, and to say the least, it was a great source of conver- From a futures price perspective, the HRW (Kansas City) sation if not consternation as it showed the price of wheat, market is near its average for this time of year while the on average, had changed little over that length of time. HRS (Minneapolis) is slightly below its average and the Unlike wheat, corn spends a good deal of its time in SRW (Chicago) above. All three markets are indicating sideways trends. A look at its historical chart indicates that they could move to higher levels this marketing year. from a risk management point of view, once one gets in The relationship between the futures market and the sync with the market's short-term pattern, strategies are cash market -- basis -- is weaker than normal in the HRW fairly simple. market, near normal in the SRW, and stronger than normal Those who try to take advantage of the soybean mar- in the HRS. This indicates the "real" fundamentals and ket, with its high volatility and explosiveness, should shows the strongest fundamentals continue to exist in the remember the old idiom, "A fool and his money are soon spring wheat (HRS) market. parted." The drop of $1.10 followed by a $.76 cent rally, The last two factors -- non-commercial trader activity all in the last two weeks, is a good reminder that options and volatility -- aren't shown on the Index charts. However, are the risk management tool of choice for soybeans, a quick look at the latest CFTC report shows non-commer- again making strategies relatively simple. cial traders, as of June 28, were liquidating part of their

Module III - What To Watch For In A Market (continued)

net-short futures position in the Chicago market and done in conjunction with a similar put strategy as the win- adding to their net-long futures position in Kansas City ter wheat markets.

and Minneapolis. This may be indicating a more bullish As for the three gentlemen listed at the top of this arti- attitude toward wheat on the floor. cle: Mr. Sutcliffe is the "fifth Beatle" who left the group Volatility continues to run higher than normal for this just before it found fame. Mr. Federer just won his third time of year, indicating larger-than-average price swings consecutive Wimbledon tennis title but could walk down are possible. almost any street without being recognized as one of the

The next step is to pull all of this information into a greats of his sport. And Mr. Kilby? He was another friend workable strategy. of the previously mentioned Mr. Hiss and a native of Great Bend, Kansas, who recently passed away. But he will I'm a realist, and my many years of working with wheat always be remembered as the recipient of the 2000 Nobel farmers have taught me there is an enormous difference Prize in physics for his work in the invention of the inte- between a theoretical strategy and a realistic strategy. grated circuit. To begin with, while the weak basis and strong carry in both the Chicago and Kansas City markets are indicating Commodity trading is very complicated and the risk of loss is substantial. the best strategy may be to hedge-and-hold in a deferred The author does not engage in any commodity trading activity for his (December) contract, the reality is that many wheat farm- own account or for others. Neither the author nor DTN make any repre- ers need an influx of cash shortly after harvest. If that's the sentations or warranty as to the accuracy or fitness for any purpose or case, max out your free storage (if available) while continu- use of the information contained in the article. The author and DTN are ing to hold put options against your crop. Once the free- not liable for any direct, indirect, or consequential loss arising from any storage program has expired, generate the much-needed use of or reliance on the information contained in this article. Neither the author of this article or DTN is a registered Commodity Trading Adviser. cash by selling your wheat and selling the put option. The information provided is general, and is NOT a substitute for your Theoretically, the best strategy would be to have a own independent business judgment or the advice of a registered December put option bought against winter wheat pro- Commodity Trading Adviser. Use this information at your own risk. duction. This will provide protection but allow for the emerging uptrend and bullish seasonal tendency to take the market higher.

As futures rally into the upper third or higher of historic price probabilities, or as the seasonal strength begins to wane, producers should look at selling March 2006 futures at 75 percent to 80 percent of full carry versus the December (13 to 14 cents in the Chicago, 12 to 13 cents in Kansas City).

Spring wheat producers should look at locking in these firm basis levels by selling HRS Index futures and buying standard Minneapolis wheat futures. Again, this could be

Glossary

AT-THE-MONEY OPTION - an option that has a strike price equal or approximately equal to the current underlying futures price

BARTERING - the exchange of goods or services for mutual advantage

BASIS - the difference between the futures price and the local cash price of a given commodity (Basis = Futures +/- Cash Price.)

BASIS CONTRACT - a forward contract where the basis is locked in for a future delivery in relation to a specified futures contract, but the deferred-month futures price remains open

BEARISH MARKET - a market in which prices are expected to fall

BUYER - a person who is looking to buy goods or services

BROKER - a person who is responsible for the execution of the purchase or sale order for his client, the buyer or seller

BROKERAGE HOUSES - places the orders to buy and sell future contracts or options on behalf of clients

BULLISH MARKET - a market in which prices are expected to rise

CALL OPTION - a contract that gives the buyer the right, but not the obligation to be long the futures market (buy a futures contract) at a later date

CASH MARKET - a market that allows a seller to make delivery of his goods or services and receive that day's price

CASH SALE - a price negotiation made on the day of delivery

CHECKOFF PROGRAM - an industry-funded generic marketing, research and new product development program established and regulated by Congress aimed at increasing demand of an agricultural commodity

CLEARING HOUSE - a department or agency of a futures exchange that is responsible for the daily settlement of all customer accounts. The clearing house guarantees all contracts by matching purchases and sales, assuring proper conduct of delivery procedures and maintaining adequate financing by member firms.

COMMODITY CERTIFICATE GAIN - the difference between the commodity exchange certificates that give the right to reclaim commodities at a rate lower than the loan rate

COMMODITY EXCHANGE ACT OF 1936 - a law passed to deal with market abuses by traders, commission merchants and exchange members by making price manipulation a criminal offense

COMMODITY EXCHANGE ACT OF 1981 - a law establishing an organization charged with regulating the activities of exchange members. The organization is called the National Futures Association.

COMMODITY FUTURES TRADING ACT OF 1974 - a law that created an independent federal body to oversee all U.S. futures trading. The regulatory body is called the Commodity Futures Trading Commission. 36

Glossary (continued)

COMMODITY FUTURES TRADING COMMISSION (CFTC) - a federal regulatory agency of the U.S. Department of Agriculture that monitors the trading in futures and options on futures markets in the U.S. CFTC approval is required for any regulatory changes or for the introduction of new futures contracts and options of an exchange. The CFTC also approves trading rules, contract terms and disciplinary procedures. The CFTC was created by the Commodity Futures Trading Act of 1974.

COMMODITY LOAN RATE - government-set price per unit of measure

CONSUMPTION - the use of goods or services

CONTRACT - a specified agreement between a buyer and seller that documents a transaction by establishing unit size, quality and delivery timing

CROP INSURANCE - policies designed for coverage of a crop in the event of a natural disaster (hail, drought, etc) so the farmer or government does not have to assume financial burden caused by significant yield loss

DAY TRADER - a person who buys and sells throughout the trading day and closes positions before the end of trading

DEMAND - a quantity of a commodity that buyers are willing to purchase from the market at a given price

DOMINANT TREND - the intermediate-term trend

DOWNTREND - a trend characterized by a series of lower highs and lower lows

EXCHANGE - a central marketplace where buyers and sellers meet to trade using established rules

EQUILIBRIUM PRICE - the price at which sellers are willing to sell their products or services and buyers are willing to buy those goods or services, also known as market price

FLOOR BROKER - a person who act as agents for customers and whose role may include taking relatively large positions in the market and holding those positions over a long period of time

FORWARD CONTRACT - a cash contract that is negotiated for delivery to take place at a specified later date

FUNDAMENTAL ANALYSIS - market analysis that focuses primarily on supply and demand

FUNDAMENTALIST - an analyst that focuses on supply and demand to forecast prices

FUTURES FIRST CONTRACT - a cash contract, but unlike the forward contract, not all the components of the forward cash price are locked in--instead the deferred futures price is set while the basis is left open, to be set before delivery. Also known as Hedge-to-Arrive Contract 37

Glossary (continued)

FUTURES MARKET - a market that has rules and regulations governing its transactions, which occur at designated exchanges

GRAIN FUTURES ACT OF 1922 - a law allowing the government some control over the exchanges by requiring them to be licensed, preventing price manipulation by their members, and providing for a continuous supply of trading information

HEDGE-TO-ARRIVE CONTRACT - a cash contract, but unlike the forward contract, not all the components of the forward cash price are locked in—instead the deferred futures price is set while the basis is left open, to be set before delivery. Also known as Futures First Contract

HEDGER - an individual or a company who uses futures exchanges to reduce the risk of actual commodity ownership or delivery obligations

IN-THE-MONEY OPTION - an option that has intrinsic value, such as a call option that has a strike price that is lower than the current underlying futures price or a put option that has a strike price above the current underlying futures price

INTRINSIC VALUE OF A PREMIUM - the relationship of the strike price to the underlying futures, the amount by which the strike price is “in the money,” “at the money” or “out of the money"

LAW OF DEMAND - the relationship between demand and price

LAW OF SUPPLY - the relationship between supply and price

LIVESTOCK RISK PROTECTION (LRP) - an insurance policy that offers protection against a decline in hog, feeder cattle, or fed cattle prices for the coverage period

LIQUID MARKETS - a market with plenty of players with plenty of cash and thus lots of buyers and sellers. Liquid markets are safer markets for all traders, including producers, because they are easier to enter and exit.

LOAN DEFICIENCY PAYMENT (LDP) - a one-time, per-bushel (or other unit of measure) government payment to producers during times of low prices

LONG HEDGE - marketing strategy involving buying futures contracts to protect against possibly rising prices when purchase is to be at a later date, also known as a buying hedge.

MARKET PRICE - the price at which sellers are willing to sell their products or services and buyers are willing to buy those goods or services, also known as equilibrium price

MARGIN - earnest money paid that allows the hedger to hold a futures contract

MARKETING - 1) taking products to market to sell; 2) communications with customers and potential customers aimed at increasing demand

MARKETING LOAN GAIN - the difference between repaying at the loan rate and repaying at the lower posted county price 38

Glossary (continued)

NATIONAL FUTURES ASSOCIATION (NFA) - an organization charged with regulating the activities of its members-brokerage houses and their agents, created by the Commodity Exchange Act of 1981.

NEUTRAL MARKET - a market that is trading at relatively stable price levels

NON-RECOURSE LOAN - a loan that has no option or means by the lender (the government), but to accept the collateral, the crop, if the borrower forfeits on his loan

OPEN INTEREST - the total number of outstanding contracts held by traders at the end of a trading session

OPEN OUTCRY - method of public trading where traders though use of their voices and hand signals buy and sell contracts

OPTION - on a futures contract is an agreement that grants a person the right, but not the obligation, to buy or sell a futures contract at a specified price before a specified time.

OUT-OF-THE-MONEY OPTION - an option that has no intrinsic value, such as a call option that has a strike price that is above the current underlying futures price or a put option that has a strike price lower than the current underlying futures price

POSTED COUNTY PRICE (PCP) - the government-calculated average of the cash commodity bids in a particular county

PREMIUM - the cost incurred to purchase a specified options contract, determined by price discovery

PRICE DISCOVERY - the interaction of buyers' asking prices and sellers' offering prices in a free marketplace, which determines price

PRICE PROBABILITY - the percent of the time a commodity has historically traded over a given price level

PRICE OF SUBSTITUTE GOODS - the price of alternate goods that can replace each other

PRICE RISK TRANSFER - the use of marketing tools that guarantee a price and shifts the risk of the price to the next level in the system

PURE HEDGE - a strategy that uses a futures contract as an offset to selling or buying the commodity in the cash market at a later date. This strategy minimizes risk and sometimes, but not always, earns more than a cash price.

PUT OPTION - a contract that gives the buyer the right, but not the obligation to be short the futures market (sell a futures contract) at a later date

SEASONAL INDEX - a historical analysis of how commodity prices have risen and fallen during a specified week or month

SECONDARY TREND - the short-term trend

SELLER - a person who is looking to sell goods or services 39

Glossary (continued)

SHORT HEDGE - a marketing strategy involving selling a futures contract to protect against possible declining prices when sale is to be at a later date, also known as a selling hedge

SIDEWAYS MARKET - a market where there isn't much gain or loss over a period of time and is expected to continue just moving along at about the same price levels

SPECULATOR - a person who buys and sells contracts with the intent to make a profit, rather than to take physical delivery of commodities underlying the contracts he's trading. Speculators assume risk in the market and provide liquidity.

STRIKE PRICE - the price at which the buyer of an option may choose to exercise the right to purchase or sell the underlying futures price

SUPPLY - the quantity of a commodity that producers are willing to bring to market at a certain price

TECHNICAL ANALYSIS - market analysis that focuses on the price fluctuations of the futures contract itself

TECHNICAL ANALYST - an analyst who follows historical price trends to forecast prices

TIME VALUE OF A PREMIUM - the amount of money buyers are willing to pay for an option in anticipation that the value of the option will increase over time due to a change in the underlying futures contract

TRADERS - people who buy and sell contracts members of the exchanges and are the ones who buy and sell contracts on the floor or in the pits of exchange.

TREND - the general direction in which prices are moving over a period of time

UPTREND - a trend characterized by higher highs and higher lows

VOLATILITY - one-standard-deviation price change, in percent, for a certain period of time