Commodity traiding

INTRODUCTION TO COMMODITY TRADING AND DERIVATIVES MARKETS  TABLE OF CONTENTS FOREWARD 3 INTRODUCTION 4 FINANCIAL DERIVATIVES 5 EMERGANCE 5 DEVELOPMENT 6 BASIC PRINCIPLES 6 PURPOSE 7 FUTURES 8 OPTIONS 10 CLEARING HOUSE 11 OPTIONS TRADING EXAMPLES 12  INTRODUCTION C ommodity trading on the exchange markets, whether in cash or in future transactions, contains all the elements of regular exchange trading. Apart of these general characteristics, however, it also has some particular features coming from the commodities as the object of trading. These specifics ask for some additional procedures within the organization of the commodity exchange, all of them attached to the very centre of the exchange market as system. In the centre of this system, organized as concentric circles, there are several functions, which all together constitutes its essence serving the exchange market’s main purpose: as simple and as effective trading as possible. Looking historically, the central functions emerged only when the ever-growing number and value of transactions forced traders to organize common execution of the part of their business. Gradually, everything which was not trading itself was moved apart from traders, so today the only action they have to perform while on the exchange market’s floor is to negotiate the prices and close the deals. All exchange markets develop in their centre functions of clearing, guaranteeing and controlling of what is traded and by whom. Also, and primarily, they develop the function of trading which consists of procedures for collecting offer and demand, announcing them, then matching and closure of transactions. Commodity exchanges, atop all of mentioned, establish relations with storages, silos, warehouses and freighters, thus dragging them into the system of exchange trading. Control of the whole trading process, as one of the exchange market functions, cannot be limited only to those who are trading, it has to focus on what is traded as well. Objects of trading are also regulated by exchange markets’ rules and regulations. They formalize and norm to the detail the characteristics of commodities to be traded on the exchange. This high standardization also serves another exchange markets’ imperative: as high as possible efficiency and safety. Trading safety demands that all participants, through all transactions and tradings, know exactly what they are trading with, and to be sure that the declared quality and quantity are just and correct. This made necessary for the exchanges to start dealing with quantity and quality control of traded commodities. and to certify that they match what is declared by the traders. The risk was, hence, took down and certainty of trading grew. Traders were freed of everything except price negotiation, they were able to trade with the commodities which were not present at the trading point. Commodity exchanges, same as securities exchanges, are the places where the word is replacing objects of trading, as well as money, up to execution of the contracts. Another imperative of exchange trading – speed and efficiency contributed to enlarge the function of control to prescription of quantity that could be traded per contract. That led to standardization of the object of trading, which was developing simultaneously with the enlarging of volume traded, providing with more order and certainty the activities on the floor. Basic quantities per contract were matching the characteristics of the commodity. Standardization of the commodity itself was only one part of the overall standardization of the trading process, starting with biding and asking, through breaking the deal, up to its execution. Licenced warehouses, thus, became part of the commodity exchange markets system. The whole exchange market system is so adjusted to trading in commodities. It is worth noticing that commodity trading in the exchange markets has been predominantly with future deliveries. Even more, the institution of the exchange market emerged, among all other reasons, from the necessity to overcome risks in trading in commodities with future deliveries. The special instrument was created upon such transactions, which took commodity exchange trading over: future contract. Future contracts, in the interim time, between the closure of the deal and its execution, became object of trading themselves. They stand in the middle between commodity and securities, constituting separate financial instrument – financial derivative. FINANCIAL DERIVATIVES F inancial derivatives are standardized contracts, or mere some contractual conditions, created as norming of futures transactions. They are based on purchasing contracts with future delivery, or future payment clause, or both of them. Judging by special conditions that are incorporated in the underlying purchasing contracts, it is possible to distinguish three basic types of them: forwards, futures and options. The first of them are the simplest, and they are not even considered as financial derivatives. They have only one special condition, which is delayed delivery of the object of trading. The other two consist, in essence, in very special conditions that are traded themselves in the exchange markets. Nuances in special conditions in derivatives contracts are now-a-days numerous, but they all still can be considered as being either futures, or options. Standardization of the financial derivatives consists of: standardization of the object of trading – commodity, or security, or exchange market indices…; standardization of the derivative content, including already standardized object of trading, then way and scope of payment, way of delivery…; standardization of writing and creating derivative, introducing to market, guaranteeing, ways of trading, collecting offer and demand, maturity and delivery dates… emergence F inancial derivatives emerged from purchasing transactions with delayed delivery. They are the expression of the effort to overcome time-frame inevitable in every economy – period from investment to profitability. Agricultural commodity transactions are placed within clear time frame. Agricultural production is seasonal, its cyclises are determined by natural laws. To produce winter wheat, nine to ten months are needed, from September-October, to Jun-July, yellow corn production demands almost as half as that, and sugar from sugar-beets half a year. This also means that first income from investment in such production will have to wait the raping season. Transactions with delayed delivery are not necessarily linked only to seasonal production. Commerce itself knows the difference between closure and execution of the deal. Every trade in goods that are placed in different markets has to take into account time for physical moving of these goods, from seller to final purchaser, from one market to another. These transactions are, so, based on place and time difference between closure and execution. development F irst transaction of this kind, with delayed delivery, which were recorded in the form of contract, could be found as back in past as clay tablets, written in cuneiforms. Ancient Mesopotamia becomes, so, place of first futures contracts, although far from exchange markets. These written obligations remind todays forwards, as simple purchasing agreements with delayed delivery of the goods. Trading in this form did not change much during the large part of economic history. It was only when such a contract was re-sold before the maturity date, that something similar to today’s exchange market transaction appeared. The essence of something which will, after long period of time, become exchange market transaction, was formed rather early. For the documents from the antique times, of course, the term ‘financial derivative’ would be pretentious. Still, the obligation of delivering something at a future date was stipulated clearly. And this obligation, not the merchandise for it was still non-existent, became the object of trading at the one point. Trading with the obligations based on non-existent merchandise or services, makes the core of exchange markets. The only thing that was separating these tradings from exchange markets as we know them today was – organization. Old Rome, at its peak, had some sort of organized trade institution, which was more than mere periodical merchants’ meetings. There continuous presence and trading was kinked to special town squares, called forum vendalium. Continuity of trade and presence allowed even some basic rules to be formed, as well as commodity standards. Finally, there is evidence that contracts with delayed delivery were being agreed there. Middle Age even made its contribution to evolution of trading elements that, later on, were combined in exchange trading. Connections among European merchants became so developed up to XI and XII centuries that merchants’ guilds started imposing some elementary organization and rules. In France and England of that time even some sort of codex, as set of rules, named Law Merchant (Lex Mercatoria) was accepted by merchants to regulate their mutual relations, including autonomous arbitration. basic principles R ules, evolved for autochthonous merchants’ law, leaned on roman law norms (i.e. ‘caveat emptor’), provide the organized trade with two principles, inseparable from the institution of exchange market: trust and safety. These two principles have become conditio sine qua non of exchange market trading, the very essence of it. Trust is cultivated by traders, exchange market members themselves, as the characteristic of their relations, and the safety slowly migrated into the domain of public interest and protection by state and its institutions. Without these two principles, every transaction, especially transaction with delayed delivery, would be unimaginable, hence the emergence and use of financial derivatives would not be possible. Different elements of organized trade joined in one trading institution, exchange market, at the beginning of Flemish renaissance, making the organization as we know it still today. Somehow at the same time, completely independent of European merchants, similar trading instruments were created in Japan, on the basis of warehouse receipts for rice, which were traded both in spot and future transactions. This confirms that exchange markets, historically, were formed spontaneously, when such an organization was needed by market participants. Development of exchange trading is inseparably connected to the development of market itself. Exchange as institution appeared spontaneously, answering to market needs. And it continued to developed simultaneously with the market and the economy. This is the reason why the emergence, spreading and development of the exchanges follow the discoveries and conquers of new markets, both geographically and technologically. Market spreading bore with new possibilities for trading, but with little knowledge of new markets and relations in them. Higher organization was so needed, to provide trade with more certainty, which all led to institutionalizing of the exchange. Standardization of the transactions and contracts followed, finally ending in three kinds of exchange trading objects as we know them today: instruments of debt (bonds), (in)corporation instruments (shares), ownership instruments (financial derivatives). Unprecedented spreading of market that marked New Age caused leap in exchange development and establishing them in cities throughout Western Europe. And this also underlines spontaneity as characteristic of forming exchanges. This makes another fact about the exchanges more obvious – same as market itself, exchange cannot deal with direct commands from outside its system. Everything which happens in it, has to be connected with the needs and trends of the market and market participants solely. Market needs will also determine the content of the standardized contracts underlying financial derivatives. purpose A ll financial derivatives serve to one basic purpose – to overcome time period from investment to profitability. Money invested in primary agricultural production, for example, has all odds to make profit, but the cycles of production is too long. Simple crediting, through bank loans, or unstandardized selling with delayed delivery, could never make agricultural profitable enough to attract sufficient investment. Derivatives created on the underlying commodities became one of the ways to address this problem. Even unstandardized forward contracts have been objects of trade themselves. Every secondary transaction with such contracts was a step towards forming exchange traded financial derivatives, which paved easy way for everyone interested in capitalization of expectations. Exchange and derivatives enable that something essentially immaterial, such is promise (IOU delivery of certain commodity at some future date), transform into the very symbol of materialistic culture, such as money. Commodity financial derivatives made profitable investments in agriculture, helping it by providing constant and perpetual inflow of finances all over the year. Every agricultural product can so be sold and bought, regardless whether it is already stored in warehouse, or being harvested, or the seeds have just been put in a soil. Interest of investors is also protected by the use of these derivatives. Their capital is not locked and they do not have to wait physical delivery of the commodity to make their profit. Their profit could be certain and made much before delivery – by mere selling of derivative issued on the basis of underlying commodity. The reason that makes contracts with delayed delivery attractive for investors lays in assumed and expected price difference between closure date and delivery date at the maturity of contract. The following graph shows this expectation: shifted time of delivery of certain commodity is followed by assumption that its price cannot be the same as the price of the commodity already procured and stored, physically existent and ready to be delivered at any agreed moment, such is commodity in spot market; greater the range between the closure of the contract and delivery of the commodity, smaller should be the price of the contract. As the range diminishes, and delivery date is approaching, the contracted commodity price and the price of the contract should tend to become equal, for the risks are smaller and disappearing, thus delivery is more and more certain. This is but a simplified model, for in reality neither the spot price, nor future delivery price go in strait line, but still it shows the basic expectation of profitability in delayed delivery transactions. 3.5 4 4.5 5 5.5 6 6.5 7 1 2 3 4 5 6 7 8 9 time value spot future Trading with contracts – derivatives becomes in time the main activity of investors, so the commodity exchanges assume much higher values of contracts, then is needed for financing agricultural production. Commodity derivatives are made means of traders’ speculation. where the sole purpose of entering in the market is not to acquire certain goods nor services, but to make profit on price difference. Agricultural commodities have one comparative advantage as underlying asset of derivatives, for their prices are supposed to go in predictable trends, determined by seasonal character oh their production: it is established and commonly known fact when is the harvest time and when the prices should be the lowest, and when is the beginning of the production making the prices the highest. That is also why meteorological reports in this market could have the same effects as breaking of some smaller wars. Interdependence of exchanges and markets they are working at, resulted in fact that certain commodities are linked to certain exchanges, in the way that some of them give the referent price for the world trade in commodities. Cereals are so connected to exchanges in Chicago, or Winnipeg, and metals for London Metal Exchange. Every derivatives exchange market creates underlying contracts adjusted to the home market and its members. Some of these contracts are now considered to be standard contract in trading with certain commodities. The others have life time of several seasons, or only one year, depending on whether and to what extent they serve the purpose of covering the risks of trade. Exchanges periodically reconsider how well the contracts are adjusted to market needs and conditions and make some changes in them accordingly, or simply reject them. FUTURES T he simplest commodity instrument is any form of commodity certificate, document that testifies the ownership of certain good, already existent and physically present on the designated place. The good is sold and re-sold by the use of this certificate, i. e. the certificate is changing the hands, from one owner to another purchaser. Still, there is no separate value in the spot market of this certificate independently of the good itself. Warehouse receipt is an example of such certificate. It is not the object of trading, rather one from the set of other underlying documents for creating derivatives. All which was said about warehouse receipt, could be said about bill of laden. The only difference consists in fact that these documents testify about the merchandise that is not in one particular place, but in process of changing places, moving from one to another. They stay instead the merchandise itself, which is traded during the transport through them. They also provided for capitalization of expectations, which led to differentiation of prices among them and the good they represented. Distance and safety are the risk factors that influence the price. The sign of commodity is, so, traded apart from the commodity it stands for. Similar ambiguity is intrinsic for another trading document – forward. Bill of laden represents the commodity which exists, but still it is not present on the place of trading, forward developed from the trade where commodity is not even existent. It is to be produced and delivered in some future time. The least developed form of forwards is unstandardized purchasing agreement, with delayed delivery, and non-transferable. If and when standardized, they can become transferable, which transforms them into separate trading instrument and object of trading, partially independent from the primary transaction they are based on. Their price is primarily influenced by the cash price of underlying commodity, but also by the risks connected to production. Next step in separating trading instrument, as sign of value, and underlying commodity, represented by this instrument, is formalized into option agreement. It evolves from one contract condition. In its developed form, created rather early, only this special condition is payed for, not the underlying commodity. The basic commodity purchasing agreement becomes, so, just one more document from the set needed for writing an option. Buying an option allows that certain commodity could be sold or purchased, by price established in advance. Depending on the wright they incorporate, options could be either call, or put options. At the maturity, at the execution of the option, contractors do not deliver not take over the commodity, but simply settle their relation by paying the difference in price between the contracted price and the price at the execution of the option. The execution could be agreed only at the maturity of the contract, which is the European type of the option, or at any demanded day by the maturity with American type of the option. It is clear that the option is almost completely independent object of trading, separated from the underlying commodity and, even more, from the basic purchasing agreement. Option is used for more sophisticated trading strategies, as well as the instrument for protection the value of assets in ever turbulent market. It has its own price, called premium, which is no0t the part of the price stipulated in basic commodity purchasing agreement. Value of the premium depends of market volatility of commodity price and it cannot be larger than the average commodity price range, otherwise the option would become useless in protection from price volatility risks. The most complex derivative in commodity exchanges is undoubtedly futures contract. His main purpose is the same as with the options, but its mechanism is different. All participants in future transactions have to provide deposit for trading and to maintain it. This deposit is called margin and it is meant to mirror the price movements until the maturity of the contract. When the trader opens future position, he pays deposit with the clearing house. This first deposit is called initial margin. Legally, it stands as bona fidae deposit by which the trader certifies that he is going to honour all the obligations that may come out of this trade. Initial margin is defined and calculated in relation to average price volatility of the underlying commodity. If the trends are such that the initial margin is not enough anymore to cover the risks, the trader will be called to pay variation margin. System of margin trading ensures enough means for covering eventual losses by every contract. All margins of one trader are calculated on the daily basis, synthesizing all his trades in one net loss or gain. The synthetic approach enables that the margins could be relatively low, which also makes trading in futures less expensive: great values and number of contracts could be traded by relatively small amounts of engaged money. Special commodity exchange bodies are in charge of calculating and norming through exchange rules the margin values, commodity by commodity. Margins should be high enough to ensure safety of trading, yet low enough to attract traders. At the maturity of the contract, physical delivery does not happen often, the contract is rather settled by paying the price difference. Derivatives – options and futures, are independent objects of trading, for they are separated during their validity time from underlying commodity. Still, the commodity remains the source, foundation and final measure of value at the maturity date. Derivatives prices so react to everything which is connected to their underlying commodities. OPTIONS W riting option means to offer in the organized exchange market wright that someone can either buy something from you, or sell something to you. In both cases, this offer is time limited, and for this certain price must be paid. To sell option means to allow unknown option buyer, for amount of money received, to sell to you, or to buy from you, through the organized exchange market, certain commodity or security. Whether the counter-party is going to exercise this wright, bought from you, depends on price movements of the commodity underlying the option contract. The price which is payed for option wright is called premium, and it is important to notice that it is not part of the price settled in underlying commodity purchasing contract. Consequently, option buyer has to take into account commodity price change which is higher than the value of premium. Every change of price lower then premium makes the option unprofitable, and it will expire unexecuted. 3 3.5 4 4.5 5 5.5 6 6.5 7 7.5 0 1 2 3 4 5 6 7 8 9 time value contract price.+premium contract price. market value The graph shows mechanism of call option. Lower flat line shows contracted value of commodity. Upper flat line represents this value with added value of premium. To make the option profitable commodity price – shown in the graph by curvy line, has to cross the upper flat line, i. e. value of contracted price plus premium. According to the graph, if the option is American type, there are three points when it could be exercised and make profit; European type, on the contrary, would expire unexercised, because at the expiration time the option will not be profitable. Put option at the graph would have premium line under the contracted price line, because the zone of its profitability is determined by deduction of premium value from the contracted price. Execution of the put option is profitable if the market price drops below the contracted price minus premium. In the price corridor between the contracted price and the premium, exercise of an option gives the possibility to lessen the loss. CLEARING HOUSE S imultaneously with derivatives trading, clearing function was developed as part of the organized trading system. Clearing could be part of the exchange itself, or it could be branched out in separate institution, but always closely connected to the exchange, always with same purpose: to make financial part of exchange transactions effective and safe. Every commodity exchange transaction goes through clearing house, in order to be settled. Clearing house provides several important tasks: keeping exchange traders accounts and their settlement, accordingly to transactions closed; monitoring and oversight of financial part of the exchange trading; collecting and maintaining the margins on the level necessary for safe trading; organizing physical delivery of contracted commodities, if necessary, at the contracts’ maturity dates; information dissemination. In its functioning clearing house becomes counter-party to every trading participant, in each transaction, thus liberating traders of direct cross-obligations towards each other – theirs is only to close the deal, after negotiating the price and the volume (number of contracts with pre-designated and standardized quantities of certain commodity). As the counter-party in every transaction, end buyer to every seller and end seller to every buyer, clearing house constitutes itself as universal guarantee of exchange trade. Traders are hence free of considerations about the ratings of their partners. Every clearing member has the obligation to maintain the level of the funds payed to clearing, accordingly to value of transactions closed and settled by clearing. Clearing can also use members’ funds for settlement of disputed transactions, which will later on be decided about. That is why clearing is not only accounting of trades, but protector of financial integrity of exchange market. OPTIONS TRADING EXAMPLES The trade in derivatives market is in most cases more complex, traders usually buy for their account and on behalf of clients, many contracts – options and futures, combining possible gains and losses. However, we will start with the simplest trades. The following four examples will show the mechanism of options trading. We will use the same contract elements for each of them: option contract is bought in May for October delivery; the object of trade is lot of 100 tons of wheat, $120 per ton, which makes the value of the deal $12,000; option premium is 10%, or $1,200, or $12 per ton. Buying call option Trader expects the rise of the wheat price above the contracted value of $120/t. If this happens, he will exercise the option and buy the wheat cheaper than the market price. For this privilege, he pays the option premium to call option seller $12/t. Option seller expects that the wheat price will not go up, so that the option buyer cannot use the option; in that case, option seller will earn the amount he received as option premium - $1,200 altogether. Profit for option buyer starts at the level of $132 ($120 contracted price + $12 premium). Break-even point for buyer is, so, $132. In the price range between $120 and $132 buy of the option can exercise the option not to make profit, but to lessen the loss. It is obvious that buyer actually limited his loss to $1,200, while the possibility to profit remains unlimited but by the market price itself. market value option value premium profit/loss 80 0 -12 -1200 90 0 -12 -1200 100 0 -12 -1200 110 0 -12 -1200 120 0 -12 -1200 130 10 -12 -200 140 20 -12 800 150 30 -12 1800 Buying call option -1500 -1000 -500 0 500 1000 1500 2000 90 100 110 120 130 140 150 Selling call option Moderate fall of wheat prices is the presumption that motivates the trader in this example. That is why he is going to sell the call option, hoping the price will not go up-wards, but quite the opposite: it will slide down below $132/t contracted $120 + $12 premium. By this trend, buyer of call option earns no profit in exercising the option. In the range between $132 and $120 will lessen his loss, and bellow $120 buyer has no interest in exercising the option. Seller of the option provides himself with gain in the slow or declining market. market value option value premium profit/loss 80 0 12 1200 90 0 12 1200 100 0 12 1200 110 0 12 1200 120 0 12 1200 130 10 12 200 140 20 12 -800 150 30 12 -1800 Selling call option -2000 -1500 -1000 -500 0 500 1000 1500 90 100 110 120 130 140 150 Selling put option Trader takes this position assuming that the price will moderately rise. So, he sells the wright to someone to sell him the wheat, but on the price lower than expected. If the assumption proves correct, the option buyer will not be interested to exercise it. Here, the trader collected option premium of $12/t, i. e. $1,200 for the whole contract. In order for this deal to be profitable for the seller, the price should stay above $108, which is break-even point calculated from contracted price minus the value of the premium. In the price zone from $108 to $120, option buyer could exercise the option in order to make the loss smaller, which would also lessen the seller’s profit. The maximum profit will remain to seller in the case that price rises above $120, for after this point there is no interest of the buyer to exercise the option, thus forcing option seller to buy wheat above market price. market value option value premium profit/loss 80 40 12 -2800 90 30 12 -1800 100 20 12 -800 110 10 12 200 120 0 12 1200 130 0 12 1200 140 0 12 1200 150 0 12 1200 Selling put option -2000 -1500 -1000 -500 0 500 1000 1500 90 100 110 120 130 140 150 Buying put option Trader expects prices to go down and thus buy put option, or the wright to sell to someone wheat. If the price does not go below $108/t, which is break-even point constituted by taking away the value of premium from the contracted price, the buyer will see no profit. In the zone from $120 to $108, the buyer could diminish the loss by exercising the option. Finally, with the price drop below $108, he will be able to make profit by exercising the option and making the option seller to buy wheat by the price above the market price. market value option value premium profit/loss 80 40 -12 2800 90 30 -12 1800 100 20 -12 800 110 10 -12 -200 120 0 -12 -1200 130 0 -12 -1200 140 0 -12 -1200 150 0 -12 -1200 INTRODUCTION TO COMMODITY TRADING AND DERIVATIVES MARKETS 13