Better Decisions: The key commodity marketing terms you should know

Monday, October 5, 2009

A checklist that will help guide you through the jungle that is the commodity markets

by JOHN BANCROFT

There is a lot of jargon tossed around in the commodity marketing world that can be confusing when you are developing and executing your marketing plan. To get you started, here is a list of definitions of some key marketing terminology.

Forward Contract. A contract for the cash sale of grain or livestock at a specified price, quantity and quality at a specified future delivery time. It is a privately negotiated contract between two parties (i.e. farmer and grain elevator).

Futures Contract. A commitment to take or make delivery of a specific quantity and quality of a commodity (for example, grain or livestock) at a predetermined place and time in the future. Except for price, all the terms of the contract are standardized and established in advance. Futures contracts are traded through a regulated commodity exchange, such as the Chicago Mercantile Exchange.

Bear Market. When prices are declining in the market.

Bull Market. When prices are rising in the market.

Short. Selling a futures contract when participating in the futures market.

Long. Buying a futures contract when participating in the futures market.

Basis. The difference between a local cash price and a specific futures contract price.

Nearby Month. The next delivery month, sometimes called the spot month.

Deferred Month. A futures month later than the nearby month.

Spread. The price difference between two futures contract months.

Offset. To take the opposite position of the original futures contract for the same delivery month. In other words, a seller of a futures contract (short position) offsets by purchasing the same number of contracts for the same delivery month.

Open Interest. The total number of futures contracts that have not been offset or fulfilled by delivery of the commodity Settlement Price. A daily settlement price is reported by a commodity exchange for each futures contract month. This is used to determine account values and margin calls.

Limit Move. The maximum change in price of a futures contract from the previous day's settlement price. The limit move amount is established by the commodity exchange. The amount of the limit move may change from time to time as market conditions dictate. The terms "limit up" or "limit down" are used depending on the direction of the price move.

Margin. The money that must be deposited in a brokerage account as a performance guarantee for futures contracts.

Margin Call. A notice that additional margin money is needed to maintain your futures contract position.

Option. This gives the right (but not an obligation) to take a futures position at a certain price (strike price) during the life of the option.

Strike Price. The price at which option holders may choose to exercise their right to sell (put) or buy (call) the underlying futures contract.

Put Option. The buyer of a put option has the right (but not the obligation) to take a short position in the underlying futures at the strike price before the option's expiration date. This sets a minimum price for the contracted amount of grain or livestock, less the cost of the option premium.

Call Option. The buyer of a call option has the right (but not the obligation) to take a long position in the underlying futures at the strike price before the option's expiration date. This sets a maximum price for the contracted amount of grain or livestock, less the cost of the option premium.

Option Premium. The price that the option trades for. It is determined through competitive bids and is offered through a commodity exchange.

Speculator. A person who attempts to profit through buying and selling, based on price changes, who has no economic interest in the commodity being traded.

Hedger. A person who produces, processes or uses commodities and who wishes to reduce their price risk or establish a price for a commodity they will be trading in the future.

Hedge. To take a futures position that is equal to and opposite a position in the cash market. The purpose is to manage the risk of an unfavourable price move in the future.
Short Hedge. To sell a futures contract or buy a put option. This is to protect against the risk of a decrease in the commodity price to be sold in the cash market in the future.

Long Hedge. To buy a futures contract or buy a call option. This is to protect against the risk of an increase in the commodity price to be purchased in the cash market in the future.

There are many other marketing terms that you will learn as you develop and execute your marketing plan. A handy resource is the factsheet, "Managing Commodity Price Risk Using Hedging and Options" available on the Ontario Ministry of Agriculture, Food and Rural Affairs (OMAFRA) website at www.ontario.ca/agbusiness.

The Chicago Mercantile Exchange (CME) website has numerous educational resources at www.cmegroup.com One example is the "Self-Study Guide to Hedging with Grain and Oilseed Futures and Options." BF

John Bancroft is the Market Strategies Program Lead with the Ontario Ministry of Agriculture, Food and Rural Affairs, Stratford. Email: john.bancroft@ontario.ca