In the first article of this series we looked at the futures market in general and why it exists. In this article we will look at how it works in terms of the buying and selling of futures contracts. We saw how futures markets came into existence so buyers and sellers could manage price and counterparty risk on the sale or purchase of a commodity in an exchange. One of the key features that was mentioned regarding exchanges was enough people with opposite trading interests. There needs to be sufficient people wanting to buy and sell so that whenever anyone else wants to buy or sell they will be able to do so, no matter the price. This is important as it means, in the case of coffee, whenever a producer or roaster would like the lock in a price for future delivery or receival, they will always be able to do so – allowing both to manage their risk and businesses better.
The Role of Speculative Traders
To guarantee liquidity in the market, the more actors participating in it, the better. This is where speculative traders come into the equation. Speculative traders buy or sell futures contracts without the intention of actually obtaining the underlying commodity. Their intention is purely financial, as they re-sell these contracts before the maturity date. They expect the price of a futures contract to move in their favor, which will produce a profit when selling or buying these contracts.
However, when we think about speculative traders in this mix, it brings to light two slightly confusing issues. Firstly, these traders do not have physical coffee to sell – they are not coffee producers, and they are not interested in buying coffee to physically receive it – they are not roasters either. So, what happens when these contracts expire? Secondly there is no limit to the number of people who can trade but there is a limit to the amount of coffee that the world can produce.
Most of all coffee futures contracts will not end in the physical delivery of the coffee, so what is going on when traders are buying and selling futures contracts. To understand this, we need to look at what it means to buy and sell a futures contracts, because it does not actually amount to buying and selling coffee. Simply put, it is to lock in a price on a commitment to buy or sell coffee in the future. This is known as taking a long or short position, essentially agreeing to buy or to sell coffee in the future for the agreed price. This means that money can be made on both price increases and decreases depending on what position a trader takes. Understanding how this market works is important to understand how companies like Caravela hedge risk to cover the coffee we buy from producers, guaranteeing the purchase and the sale to the roaster, and in doing so covering the risk of all parties involved, as much as it is physically possible.
A Trade Example
So, let’s look at an example of a trader looking to make money on a price increase:
Our speculative trader buys a futures contract or goes long at the start of the year for delivery in December for x price. This trader is hoping that the price will go up. If the trader holds on to the contract until its expiration then he will have to buy the contract’s worth of coffee for x price. A few months pass and the price goes up, but what can the trader do to take advantage of this? They are already committed to buying in December at x price, so they need to offset their long position, to take advantage of their obligation to buy. To do so, the trader will sell a futures contract, or go short, for delivery in the same month as the original, so in December, but for the current higher price of y. This effectively balances out the original contract, in a process known as novation.
This trader technically must buy 37,500 lbs. of coffee in December for x and must sell 37,500 lbs. of coffee in December for y, but physically doing this is not necessary. The contracts offset each other and the exchange’s open interest, which is the number outstanding open contracts that the exchange has at any one time, will also register the close. The trader will book a profit if y is higher than x.
As the contract was balanced out with another one, does it really matter if the coffee existed or not? And if not, does it then matter if the seller is a coffee producer or not? Or if the person buying a futures contract is actually a roaster, planning to receive the physical coffee for their business or just buying and then selling before the expiration of the contract? These are important question to understand the workings of the futures market. Yes, all contracts will expire but if all contracts can be novated, i.e. balanced out, then this means that the actual projected production of coffee is not a limit to the size of the futures market. Yes, a producer can sell a futures contract of coffee and physically deliver it. Yes, a roaster can buy a futures contract and physically receive the coffee. But it is also possible to buy and sell many futures contracts with no intention of delivering or receiving physical coffee.
Other Details to Bear in Mind
The example above is quite simplified as in reality to buy and sell futures contracts many things need to happen in the background. Perhaps the most important is that the interested party must open (and fund) a trading account with a member firm or broker. A trading account is similar to a bank account that needs to be funded based on market movements and the owner of the account must be able to provide an initial margin (a security payment) and continuously fund margin calls (running profit or loss). Although you don’t need to pay the full amount of the contract when buying a futures contract, and so are effectively trading with a margin, changes in price in an undesirable direction for your position can quickly result in your margin being insufficient to cover the loss.
The way this market is set up means that most of the individuals buying and selling coffee futures will never want or have the physical coffee and the amount of coffee that is being traded doesn’t and will never actually exist in the world. Traders make up the grand proportion of these transactions, but this does not mean that the risk mitigation role these contracts also play is any less important.
In the final article of this series we will look closer at the key role that hedging plays for companies like Caravela and how the futures market allows us to mitigate the underlying price risk of selling coffee forward.
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