Commodities futures

You might have heard of people making money from trading commodity futures. I'm here to make it clear once and for all. Yes, you can make money from trading commodity futures. You can trade any commodity ranging from rice, and wheat to pork belly and oil.

Here's how it all began.

Given the urban nature of the city of Chicago, we often forget that it is located in the agricultural market center for neighboring states. Chicago was the meeting place for farmers looking for buyers of their crops and grain mills looking to purchase product for their operations. However, despite the central location, timing and logistic issues created inefficient means of conducting business and thus inflated commodity prices.

At the time, grain elevators were sparse, which made it critical that a farmer sell his crop upon harvest at the annual meeting in Chicago due to a lack of storage. Even for those who did have a method of storing the grain, frozen rivers and roadways made it nearly impossible to travel to Chicago during winter months. Likewise, the springtime trails were often too muddy for wagon travel. Thus, during and immediately after harvest, grain supply was in such abundance that it was common for unsold grain to be dumped into Lake Michigan for lack for means to transport and store unsold portions.

As you can imagine, as the year wore on, the grain supply would dwindle to create shortages. This annual cycle of extreme oversupplies and subsequent undersupplies created inefficient price discovery and led to hardships for both producers and consumers. The feast or famine cycle created circumstances in which farmers were forced to sell their goods at large discount when supplies were high, but consumers were required to pay a large premium during times of tight supplies. Luckily, a few of the grain traders put their heads and resources together to develop a solution…an organized exchange now known as Chicago Board of Trade.

The Chicago Board of trade (CBOT) was created by a handful of savvy grain traders to establish a central location for buyers and sellers to conduct business. The new formalized location and operation enticed wealthy investors to build storage silos to smooth the supply of grain throughout the year and, in turn, aid in price stability.

The CBOT is still located in downtown Chicago and is the world’s oldest future exchange. After spending the last decade and a half as one of the largest future trading organizations in the world and a direct competitor to Chicago Mercantile Exchange (CME), the CBOT and the CME merged in 2007 to form the CME Group, creating the largest derivatives market ever!

The CBOT division of CME Group is the home of trading of agricultural products such as corn, soybeans, and wheat. However, the exchange has added several products over the years to include Treasury bonds and notes and the Dow Jones Industrial Index.

The success of the CBOT fueled investment dollars into exchanges that could facilitate the process of trading products other than grain. One of the offsprings of this new investment interest is the Chicago Mercantile Exchange. The CME was formed in 1874 under the operating name Chicago Produce Exchange; it also carried the title Chicago Butter and Egg Board before finally gaining its current name.

The CME is responsible for trading in a vast variety of contracts including cattle, hogs, stock index futures, currency futures, and short-term interest rates. The exchange also offers alternative trading vehicles such as weather and real estate derivatives. At the time of this writing, and likely for some time to come, the CME has the largest open interest in options and futures contracts of any futures exchange in the world.

The futures markets and the instruments traded there, as we know them today, have evolved from what began as private negotiations to buy and sell commodities between producers and users. The agreements that resulted from these negotiations are known as forward contracts. Fortunately, efficient-minded entrepreneurs discovered that standardized agreements can facilitate transactions in a much quicker manner than a privately negotiated forward contract, and thus, the future contract was born.

A forward contract is a private negotiation developed to establish the price of a commodity to be delivered at a specific date in the future. For example, a farmer that has planted corn and expects it to be harvested and ready to sell in October might locate a party interested in purchasing the product in October. At that time, both parties interested in purchasing the product in October. At that time, both parties may choose to enter an agreement for the transaction to take place at a specific date, price and location. Such an agreement locks in the price for both the buyer and the seller of the commodity and, therefore, eliminates the risk of price fluctuation that both sides of the contract face without the benefit of a forward contract.

Along with a centralized grain trade, the forward contract was big step forward price stability, but there was a problem. Forward contracts reduce price risk only if both parties to the arrangement live up to their end of the agreement. In other words, there is no protection against default. As you can imagine, a farmer that locks in a price to sell his crop in the spring through a forward contract and discovers that he can sell the product for considerably more in the open market might choose to default on the forward contract.

It is easy to see the lack of motivation for parties to a forward contract to uphold their end of the bargain. Even the most honest man would be tempted to default if it means a better life and less suffering for his family.

To resolve this issue of merchants and farmers defaulting on forward contracts, the exchanges began requiring that each party of the transaction deposit a good faith deposit, or margin, with an unrelated third party. In the case of failure to comply with the contract, the party suffering the loss would receive the funds deposited in good faith to cover the inconvenience and at least part of the financial loss.

Because forward contracts were negotiations between two individuals, it was a challenge to bring buyers and sellers together that shared the same needs in terms of quantity, timing and so on. Also, forward contracts were subject to difficulties arising from incontrollable circumstances such as drought. For example, a farmer obliged to deliver a certain amount of corn via a forward contract might not comply due to poor growing conditions, thus leaving the counter-party to the transaction in a dire predicament.

The exchanges’ answer to problems arising from forward contracts was the standardized future contract. In its simplest form, a future contract is a forward contract that is standardized in terms of size, deliverable grade of the commodity, delivery date, and delivery location. The fact that each contract is identical to the next made the trading of futures much more convenient than attempting to negotiate a forward contract with an individual. It is the concept of standardization that has allowed the futures markets to flourish into what they have become today.

According to the CME, the formal definition of a future contracts is as follows:
“A legal binding, standardized agreement to buy or sell a standardized commodity, specifying quantity and quality at a set price on a future date”

In other words, the seller of future contracts agrees to deliver the stated commodity on the stated delivery date. The buyer of a futures contract agrees to take delivery of the stated commodity at the stated delivery date. The only variable of a future transaction is the proce at which it is done, and this is determined by buyers and sellers in the marketplace.

Although the future contacts bought or sold represent an obligation to take or make delivery, according to the CME approximately 97% of future contracts never resulted in physical delivery of the underlying commodity. Instead traders simply offset their holding prior to the expiration date.

Thanks to the standardization of each contract, the subsequent ease of buying and selling contracts, and a lack of default risk, futures trading has attracted price speculation. Participation is no longer limited to those who own, or would like to own, the underlying commodity. Instead unrelated third parties can easily involved themselves in the market in hopes of accurately predicting, and therefore profiting from, price fluctuations. And for your information, I’m one of them.

Has anyone heard of an exchange for health-products such as bird nest, shark fin, and black fungus? As you can see, how much trouble we can eliminate if there were an exchange for these products.

Thank you.