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What is a Hedger?

Hedgers are primary participants in the futures markets.  A hedger is any individual or firm that buys or sells the actual physical commodity.  Many hedgers are producers, wholesalers, retailers or manufacturers and they are affected by changes in commodity prices, exchange rates, and interest rates. Changes to any of these variables can impact a firm’s bottom line when they bring goods to the market. To minimize the effects of these changes hedgers will utilize futures contracts. Unlike speculators who assume market risk for profit, hedgers use the futures markets to manage and offset risk.

Corn Hedger Example

Let’s look at an example of a corn farmer. In the spring, the farmer is concerned about the price for his crops when he sells in the fall.  If prices drop at harvest, the farmer will have to sell the crop at a lower price.

One way the farmer could hedge his exposure would be to sell a corn futures contract. When harvest rolls around and the price of corn drops, he will see a loss in price when he sells his crop in the local market, however that lose would be offset by a trading gain the futures market.  If prices rallied at harvest, the farmer would have a trading loss in the futures market but his crop would be sold at a higher price in the local market.

In either scenario, the hedged farmer has added protection against adverse price movements. The use of futures enabled him to establish a price level well before the he sells the crop in his local market.

Types of Hedgers

There are several types of hedgers in the commodities markets:

• Buy-side Hedgers: Concerned about rising commodity prices
• Sell-side Hedgers: Concerned about falling commodity prices
• Merchandisers: They both buy and sell commodities.  Their risk is different than the directional risk of a traditional buying and selling hedger. Their risk is the spread or difference between the purchase and selling prices that determines their profitability.

Summary

Many industries now use the risk management potential of futures contracts for a variety of assets.  The profitability of a construction company partially depends on the cost of building materials.  By purchasing a steel futures contract, the firm is able to secure a price at which it acquires steel.   Conversely, steel mills worried about a decline in building demand and the drop in steel prices can sell steel futures contracts to protect against that price movement.

Airlines now hedge against rising fuel costs through the use of crude oil futures. And jewelry manufacturers can hedge against gold and silver price movement by utilizing precious metals futures contracts.

When it comes to hedging, there are a variety of market participants who buy and sell physical commodities, and they may benefit from the added price protection offered by futures and options contracts.

If you have questions send us a message or schedule an online review.

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Peter Knight Advisor

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Calculating Futures Contract Profit and Loss 

Market participants trade in the futures market to make a profit or hedge against losses. Each market calculates movement of price and size differently, and as such, traders need to be aware of how the market you are trading calculates profit and loss. To determine the profit and loss for each contract, you will need to be aware of the contract size, tick size, current trading price, and what you bought or sold the contract for. WTI Crude Oil futures, for example, represents the expected value of 1,000 barrels of oil. The price of a WTI futures contract is quoted in dollars per barrel. The minimum tick size is $0.01.

Current Value

If the current price of WTI futures is $54, the current value of the contract is determined by multiplying the current price of a barrel of oil by the size of the contract. In this example, the current value would be $54 x 1000 = $54,000.

Value of a One-Tick Move

The dollar value of a one-tick move is calculated by multiplying the tick size by the size of the contract.

The dollar value of a one-tick move in WTI is $0.01 x 1000 = $10

Calculation Example

Calculating profit and loss on a trade is done by multiplying the dollar value of a one-tick move by the number of ticks the futures contract has moved since you purchased the contract. This calculation gives you profit or loss per contact, then you need to multiply this number by the number of contracts you own to get the total profit or loss for your position.

A trader buys one WTI contract at $53.60.

The price of WTI is now $54.

The profit-per-contract for the trader is $54.00-53.60 = $0.40

Therefore, the contract has moved $0.40 divided by $0.01 = 40 ticks

The total move in dollars is 40 ticks x $10 per tick = $400

The total profit would be $400 x the number of contracts the trader owns

Losses are calculated in the same manner as gains.

The Value of Your Position 

The size of the contract can have a considerable multiplying effect on the profit and loss of a specific futures contract. Before entering a position in the futures market, it is critical that you understand how any price fluctuation or market volatility affects the value of your open trading position. Consider the average price move for the contract and the corresponding tick value to understand the size of typical moves and its value.

For example, the 14-day average true range is 15 for the ES and 0.32 for Silver futures (SI) .

The calculation is as follows:

The value of a typical daily move in dollars for the ES contract = 7.5 points x $50 per point = $375

Compared to the ES contract, the SI contract is a larger contract with larger moves.

The average true range or ATR for the SI contract  $0.16 = 160 ticks

The value of a typical daily move in dollars is 160 ticks x $5 per tick = $800

This example illustrates that on average the ES contract moves less than half the dollar value of the SI contract.

Some average moves in the larger valued futures contracts can be sizable, and traders should plan their risk and reward accordingly.

If you have questions send us a message or schedule an online review.

Regards,
Peter Knight Advisor

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The Lifespan of a Futures Contract

Futures contracts have a limited lifespan that will influence the outcome of your trades and exit strategy. The two most important expiration terms are expiration and rollover.

Contract Expiration Options

A contract’s expiration date is the last day you can trade that contract. This typically occurs on the third Friday of the expiration month, but varies by contract.

Prior to expiration, a futures trader has three options:

Offset the Position

Offsetting or liquidating a position is the simplest and most common method of exiting a trade. When offsetting a position, a trader is able to realize all profits or losses associated with that position without taking physical or cash delivery of the asset.

To offset a position, a trader must take out an opposite and equal transaction to neutralize the trade. For example, a trader who is short two WTI Crude Oil contracts expiring in September will need to buy two WTI Crude Oil contracts expiring on the same date. The difference in price between his initial position and offset position will represent the profit or loss on the trade.

Rollover

Rollover is when a trader moves his position from the front month contract to a another contract further in the future. Traders will determine when they need to move to the new contract by watching volume of both the expiring contract and next month contract. A trader who is going to roll their positions may choose to switch to the next month contract when volume has reached a certain level in that contract.

When rolling forward, a trader will simultaneously offset his current position and establish a new position in the next contract month. For example, a trader who is long four S&P 500 futures contracts expiring in September will simultaneously sell four Sept ES contracts and buy four Dec or further away ES contracts.

Settlement

If a trader has not offset or rolled his position prior to contract expiration, the contract will expire and the trader will go to settlement. At this point, a trader with a short position will be obligated to deliver the underlying asset under the terms of the original contract. This can be either physical delivery or cash settlement depending on the market.

You have choices when it comes to your futures positions at expiration. Knowing how you want to manage your trades around rollover and expiration is important as it will directly impact the outcome of the trades.

If you have questions send us a message or schedule an online review.

Regards,
Peter Knight Advisor

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Price discovery

Price discovery refers to the act of determining a common price for an asset. It occurs every time a seller and buyer interact in a regulated exchange. Because of the efficiency of the futures markets and the ability for the instant dissemination of information, bid and ask prices are available to all participants and are instantly updated across the globe.

Price discovery is the result of the interaction between sellers and buyers, or in other words, between supply and demand and occurs thousands of times per day in the futures markets.

This auction type environment means that a trader can find trades that they feel are fair and efficient. For example, a trader in Europe trading Corn futures (ZC) contract and a trader in Australia trading the same contract will see the same bid and ask quotes on their trading platforms at the same time, meaning that the transaction is transparent.

The bids and offers on the futures market constantly change with supply and demand, and with news from around the world. Since every piece of news could potentially impact the supply or demand of a specific asset, buyers and sellers adjust their prices to reflect these changing factors with every trade that is made in that market, hence why price is always fluctuating.

What does this all mean to a trader?

It means that you can rely on the quotes you are seeing on your screen, and trade with the knowledge that you are getting the best price, and the same price, as all others trading the same product at the same time. The one-lot order of a retail trader is treated the same as a 100-lot order from an institutional trader, and they will both pay or receive the same price for their contracts.

The open auction system means that all available information has been assimilated in to the current price of the product, increasing market efficiency and improving the reliability of price from one trade to the next.

The result is a global marketplace for the fair, efficient and transparent discovery of market price.

If you have questions send us a message or schedule an online review.

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Peter Knight Advisor

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Contract Unit

The contract unit is a standardized size unique to each futures contract and can be based on volume, weight, or a financial measurement, depending on the contract and the underlying product or market.

For example, a single COMEX Gold contract unit (GC) is 100 troy ounces, which is measured by weight.

A NYMEX WTI Crude Oil contract unit (CL) is 1,000 barrels of oil, measured by volume.

The E-mini S&P 500 contract unit (ES) is a financial calculation based on a fixed multiplier times the S&P 500 Index.

Contract Notional Value

Contract notional value, also known as contract value, is the financial expression of the contract unit and the current futures contract price.

Determining Notional Value

Assume a Gold futures contract is trading at price of $1,000. The notional value of the contract is calculated by multiplying the contract unit by the futures price.

Contract unit x contract price = notional value

100 (troy ounces) x $1,000 = $100,000

If WTI Crude Oil is trading at $50 dollars and the contract unit is 1000 barrels, the notional would be;

$50 x 1,000 = $50,000

Now assume E-mini S&P 500 futures are trading at 2120.00. The multiplier for this contract is $50.

$50 x 2120.00 = $106,000

The Importance of Contract Unit and Notional Value

Notional values can be used to calculate hedge ratios versus other futures contracts or another risk position in a related underlying market.

Hedge Ratio

How might a portfolio manager, with a $10M U.S. equity market exposure, use notional value of E-mini S&P 500 futures to determine a hedge ratio?

Hedge ratio = value at risk/notional value

We can determine the hedge ratio using our previous example of the E-mini S&P 500 futures with a value of $106,000.

Hedge ratio = 10,000,000/106,000

Hedge ratio= 94.33 (approximately 94 contracts)

If the portfolio manager sells 94 E-mini S&P 500 futures against her long equity cash position, she has effectively hedged her market risk.

If you have questions send us a message or schedule an online review.

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Peter Knight Advisor

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What is Mark-to-Market?

One of the defining features of the futures markets is daily mark-to-market (MTM) prices on all contracts. The final daily settlement price for futures is the same for everyone.

MTM was a distinctive difference between futures and forwards until the regulatory reform enacted after the financial crises of 2007-2008. Prior to those reforms most OTC forwards and swaps did not have an official daily settlement price so clients never knew their daily variation except as described by a theoretical pricing model.

Futures markets have an official daily settlement price set by the exchange. While contracts may have slightly different closing and daily settlement formulas established by the exchange, the methodology is fully disclosed in the contract specifications and the exchange rulebook.

Example

Corn futures trade on CME Globex beginning the previous evening and officially settle for the day at 13:15 Central Time (CT). CME Group staff determine the daily settlement price of corn based on trading activity in the last minute of trading between 13:14:00 and 13:15:00.

E-mini S&P 500 futures trading on CME Globex begin trade the previous evening (CT) at 5:00 p.m. The final daily settlement price is determined by a volume-weighted average price (VWAP) of all trades executed in the full-sized, floor-traded (the Big) futures contract and the E-mini futures contract for the designated lead month contract between 15:14:30 and 15:15:00 CT. The combined VWAP for the designated lead month is then rounded to the nearest 0.10 index point. This contract then remains closed for fifteen minutes between 15:15:00 and 15:30:00 and then resumes trading until 16:00:00 (4:00 p.m. CT) when CME Globex shuts down for one hour.

U.S. Treasury futures begin trading on CME Globex at 5:00 p.m. CT and will trade through the next day until 4:00 p.m. CT. However, the daily settlement price is established by CME Group staff based on trading activity on CME Globex between 13:59:30 and 14:00:00 CT.

In order to fully appreciate a futures contract’s final daily settlement price one needs to know the settlement procedures defined in the contract’s specifications.

Once a futures contract’s final daily settlement price is established the back-office functions of trade reporting, daily profit/loss, and, if required, margin adjustment is made. In the futures markets, losers pay winners every day. This means no account losses are carried forward but must be cleared up every day. The dollar difference from the previous day’s settlement price to today’s settlement price determines the profit or loss. If my daily loss results in my net equity falling below exchange established margin levels I will be required to provide additional financial resources to replenish the amount back to required levels or risk liquidation of my position.

Mark-to-market enforces the daily discipline of exchanges profit and loss between open futures positions eliminating any loss or profit carry forwards that might endanger the clearinghouse. Having one final daily settlement for all means every open position is treated equally. By publishing these daily settlement values the exchange provides a great service to commercial and speculative users of the futures markets and the underlying markets they derive their price from.

If you have questions send us a message or schedule an online review.

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Peter Knight Advisor

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What are Price Limits?

As a trader, you want to know that there are mechanisms in place to ensure an orderly market. A regulated marketplace like CME Group provides this order by setting price limits and price banding.

Price Limits

Price limits are the maximum price range permitted for a futures contract in each trading session. These price limits are measured in ticks and vary from product to product. When markets hit the price limit, different actions occur depending on the product being traded. Some markets may temporarily halt until price limits can be expanded or trading may be stopped for the day based on regulatory rules. Different futures contracts will have different price limit rules; i.e. Equity Index futures have different rules than Agricultural futures.

Example

Equity Indexes futures have a three level expansion: 7%, 13% and 20% to the downside, and a 5% limit up and down in overnight trading. Agricultural futures like Corn have a two level expansion: $0.25 then $0.40.

When price reaches any of those levels the market will go limit up or limit down.

Calculating Price Limits

Price limits are re-calculated daily and remain in effect for all trading days except in certain physically-deliverable markets, where price limits are lifted prior to expiration so that futures prices are not prevented from converging on prices for the underlying commodity.

Typically, Agricultural futures will go limit up or down most often compared to Equity Index futures which very rarely if ever go limit up or down. When trading a specific product, it is important to be aware of price limits and the mechanisms that occur when limits are hit. Traders also know that it is possible for limits to be reached for more than one session in a row, however the expansion of limit thresholds over the last few years have reduced this occurrence.

Price Banding

Price banding is a similar mechanism which subjects all orders to price validation and rejects orders outside the given band to maintain orderly markets. Bands are calculated dynamically for each product based on the last price, plus or minus a fixed band value. Thus, if markets quickly move in one direction, the price bands dynamically adjust to accommodate new trading ranges.

Conclusion

The rules for each market can be found on cmegroup.com.

It is important to note that traders can place trades outside the daily price limits. These trades will be executed when price limits and price bands move within the specified range. So, traders still have the ability to place good-til-canceled or good-til-date orders inside and outside daily price limits.

In the last few years there are fewer and fewer times that markets will actually go limit up or down, but it is important to be aware of these pricing rules when you trade.

If you have questions send us a message or schedule an online review.

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Peter Knight Advisor

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Minimum Price Fluctuation

All futures contracts have a minimum price fluctuation also known as a tick. Tick sizes are set by the exchange and vary by contract instrument.

E-min S&P 500 tick

For example, the tick size of an E-Mini S&P 500 Futures Contract is equal to one quarter of an index point. Since an index point is valued at $50 for the E-Mini S&P 500, a movement of one tick would be

.25 x $50 = $12.50

NYMEX WTI Crude Oil

One NYMEX WTI Crude Oil futures contract is 1,000 barrels of oil. This contract is quoted in dollars and cents per barrel. Therefore a one cent, or one tick, move in the WTI contract is worth $10.

1,000 x $.01 = $10

Summary

Tick sizes are defined by the exchange and vary depending on the size of the financial instrument and requirements of the marketplace. Tick sizes are set to provide optimal liquidity and tight bid-ask spreads.

The minimum price fluctuation for any CME Group contract can be found on the product specification pages.

If you have questions send us a message or schedule an online review.

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Peter Knight Advisor

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Overview of Expiration and Settlement

Expiration

All futures contracts have a specified date on which they expire. Prior to the expiration date, traders have a number of options to either close out or extend their open positions without holding the trade to expiration, but some traders will choose to hold the contract and go to settlement.

Settlement

Settlement is the fulfillment of the legal delivery obligations associated with the original contract. For some contracts, this delivery will take place in the form of physical delivery of the underlying commodity. For example, a food producer looking to acquire grain may be looking to take delivery of physical corn or wheat, and a farmer may be looking to deliver his grain to that producer. Although physical delivery is an important mechanism for certain energy, metals and agriculture products, only a small percent of all commodities futures contracts are physically delivered.

In most cases, delivery will take place in the form of cash settlement. When a contract is cash-settled, settlement takes place in the form of a credit or debit made for the value of the contract at the time of contract expiration. The most commonly cash-settled products are equity index and interest rate futures, although precious metals, foreign exchange, and some agricultural products may also be settled in cash.

For traders choosing to go to settlement, the form of delivery will be highly dependent on the needs of each trader, as well as the unique characteristics of the product being traded.

If you have questions send us a message or schedule an online review.

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Peter Knight Advisor

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