For the first time in eight years, I teach a course called Futures and Options Markets at the University of Minnesota. Futures markets are at the center of grain and livestock pricing systems. I intend to cover a lot of ground over 15 weeks, and no student can expect to remember every pearl of wisdom offered by the teacher. Here are a few concepts I want them to remember 10 years from now.
BASIS: Basis in any market is simply the local cash price less the futures price. Most students will start the course with the belief that the best grain merchandisers, elevator managers and processors are the players who can best predict the direction of the futures market. Not true. My experience shows that the most successful players are those with the best understanding of basis.
For most grain exporters, merchandisers and processors, hedging is standard operating procedure. That means that every grain purchase is offset by a futures sale, and every grain sale is offset by a futures purchase. The direction of the futures market means little to a hedger, but anticipating the basis is critical. Understanding your local basis simply means that you understand cash prices in your local market, and how they relate to the futures market.
Basis is important to growers, too. Do you have a good understanding of what drives your local basis?
CARRYING CHARGES: Carrying charges are the price differences between different futures delivery months (e.g., March vs. July corn futures or May vs. August soybean futures). Most students will start the course with the belief that these price differences are the result of expectations about the future. In other words, if March corn futures are trading at $4.40/bu. while July futures are trading at $4.50 (a 10¢ positive carrying charge), the market is simply reflecting traders' expectations of higher corn prices in the months ahead.
Wrong! In storable commodities like grains, carrying charges are market-determined storage costs and they speak volumes about the value of storage and the tone of a market. Large carrying charges are common when stocks are large - the bear market environment. They offer an incentive to merchandisers to store grain and sell the carry. Carrying charges are small or inverted (negative carrying charges) when stocks are low - a bull market environment. Inverted markets are a disincentive to storage and signal merchandisers to pull existing stocks out of storage. Many producers have storage, too. What are the carrying charges telling you about the tone of the market and the value of storage?
The best grain traders pay just as much attention to the direction of carrying charges (is the carry getting larger or smaller?) as they do to the direction of prices.
HEDGING VS. SPECULATION: Both hedgers and speculators play an important role in a healthy futures market. The reintroduction of options 25 years ago created an incredible number of complex trading strategies, and a big gray area between accepted definitions of legitimate hedge and spec transactions. I want my students to understand that the third time they re-own a crop with call options, they have slipped into the speculative side of the ledger.
Now sit up straight, turn off your cell phone and no chewing gum. Class is about to begin.
Ed Usset is a grain marketing specialist for the University of Minnesota Center for Farm Financial Management (CFFM). He can be reached at firstname.lastname@example.org.