The purpose of this text is to provide you with the necessary information to use these markets in a successful and, hopefully, profitable manner. It is important to recognize that forward pricing does not guarantee the highest possible price for grain sold. At the same time, it is not always imperative to forward price if market prices are not to your liking. Therefore, our goal in this text is not only to help you understand the mechanisms that you can use to establish forward prices, but also give you the tools necessary for understanding when to make a pricing decision.

This reference guide has five major chapters. This chapter presents some discussion of grain futures markets. It also discusses some of the issues related to trading in the futures market including working with a commodity futures broker. This chapter is intended for those who have a limited understanding of futures markets.

Chapter 2 and 3 discuss how to use commodity futures markets to establish forward prices for your commodities. Chapter 2 is devoted exclusively to using futures markets while section 3 discusses using commodity options. Throughout, a number of examples are used to illustrate how these methods work.

Chapter 4 and 5 present some of the basic tools of fundamental and technical analysis. Fundamental analysis is the use of commodity supply and demand data to make price projections. In chapter 4, we show some simple fundamental analysis can be used to predict commodity prices and help you know when to establish a price using a forward pricing contract. Chapter 5 discusses some simple technical analysis techniques which are based on commodity chart patterns.


A. Futures Markets: What Are They?

Futures markets offer an opportunity to establish a forward price for your crop in advance of when it will be delivered to a local buyer. This can include pricing wheat (or other crop) well in advance of when you will actually produce it and sell it in your local market. While a common misperception is that futures markets are nothing more than gambling arenas, the truth is futures markets can be used to increase profitability and lower risk.

In a nutshell, futures markets are simply auction markets for forward contracts, except in futures markets they are called futures contracts. We are all familiar with forward contracts--a legal agreement between a buyer and a seller to exchange a product at a later date and at a predetermined price. In most cases, the "seller" of the forward contract is the farmer while the "buyer" is a local grain elevator or merchandiser.

A futures contract is similar except that the size and delivery date of a futures contract is standardized so that no one can change the contract specifications. In fact, the only thing that is negotiated is the price. The terms of the futures contract dictate what commodity will be exchanged (e.g., corn), the amount of the commodity that will be exchanged (e.g., 5,000 bushels) and the date when the exchange will occur, often called the contract month (e.g., May).

The Futures Exchange

Futures exchanges are government licensed markets for the trading of futures contracts. There are numerous futures exchanges not only in the U.S. but also around the world. For agriculture, the three primary futures exchanges are the:

• ·Chicago Board of Trade (CBT) where grain and oilseed futures contracts are traded;
  
• ·Chicago Mercantile Exchange (CME) which trades livestock and dairy products;
  
• ·Mid-American Exchange of Chicago trades smaller sized contracts of agricultural products.
  

The exchanges provide space (called pits) where traders meet during a specified time period to trade futures contracts. At the CBT, the grain and oilseed contracts trade from 9:30 a.m. (Central Standard Time) to 1:20 p.m.. Individuals who trade contracts in the pits are exchange members and may trade their own accounts or take orders from brokers or businesses outside of the exchange.

Who Trades Futures Contracts?

People who trade futures contracts are either speculators or hedgers. Hedgers, who are also referred to as commercial users, protect their financial position in the cash market by using futures contracts to protect against adverse price moves. A grain elevator who signs a forward contract with a local farmer will utilize futures contracts to remove the risk of price changes. Farmers and other business that face a risk of loss from adverse price moves can also use futures.

The other group of traders is speculators who have no business interest in the agricultural commodity. Their sole interest is to try and predict price direction and profit from such forecasts. Some suspect that speculators control the futures market by either making prices too high or too low. However, because there are so many individuals—both hedgers and speculators—trading in futures markets, it is impossible for any one person or group of individuals to control the price. While we may not always like the prices offered on futures contracts, they are still the best indication of what is a fair-value for the commodity in the future. Granted, futures prices may and do often change dramatically, but this is a consequence of new supply or demand information, which changes the fundamental outlook. Being a good marketer will allow you to profit from such changes through a forward pricing arrangement.


B. Trading Futures Contracts

Trading futures contracts is not a complex process and has many similarities to trading stocks. However, some important differences exist between trading stocks and trading futures contracts that are worth discussing.

Brokers
To trade in the futures market requires that you have an account with a futures broker. Like stock brokers, futures brokers may provide trading advice. Brokers will send you an account statement and will handle the funds that you use to trade. For their services, brokers charge a commission which varies, depending on the level of service, from $25-$75 per contract. We will discuss brokers in more detail in a later section. For the moment, just recognize that you will need to use a futures broker to trade in the futures market.

Futures Contracts
Futures contracts are agreements between two parties. Like a forward contract, there is a buyer of the commodity (sometimes called the ''long'') and a seller of the commodity (a ''short''). You can sell futures contracts without actually having pre-existing futures contracts. As a seller or the short, you are agreeing to deliver the commodity in the delivery month. The buyer or the long is agreeing to take delivery of your commodity in the delivery month.

Now, these obligations to make or accept delivery of a commodity sound quite demanding but the benefit of futures contracts is that they can be canceled or offset anytime prior to when the contract expires. To offset a futures contract, you simply do the opposite of what your existing position is. For example, if you have gone short (sold) a December corn futures contract today, then you can simply offset it anytime between now and December by buying December corn futures. This will offset your delivery obligation. However, over that time, the December corn futures price has likely changed. If the price has fallen and you buy it back at a lower price, you will have a profit in your account. Conversely, if you have to buy back at a higher price, you will have to pay the difference.

Margins and Mark-to-Market
Anytime you take a position in the futures market (either long or short) you are required to post margin funds. Margin is a small sum of money, which serves as good faith indicating that you will adhere to the terms of the contract. Margins usually range from $500 to $1,500 per contract depending on the commodity and the market volatility at the time.

Another unique feature of futures contracts as compared to stocks is that profits and losses are settled on a daily basis. On any given day, there are winners and losers in the futures markets depending on their position and the change in price from the previous day. Margin funds are used to pay those who have profited from those who have lost. This adding and subtracting from your account on each day is known as mark-to-market.

For example, if prices increase, then those having a long futures position will win and those having short positions will lose. The losers will have money taken from their account to pay the winners. Therefore, one of the main purposes of margin funds is to provide enough funds to assure that you can meet these obligations if your account suffers a loss.

C. Grain Futures Markets

The largest futures exchange in the world for trading grain and oilseed products is the Chicago Board of Trade (CBT). In fact, grain traders in Chicago who wanted a standardized way to trade cash forward contracts started the CBT in the mid-1800s.

The CBT trades futures contracts for corn, wheat and soybeans (including soymeal and soyoil). The contracts are for 5,000 bushels and have delivery or contract months which differ depending on the commodity.

While the CBT is the largest grain futures exchange, there are other grain exchanges which may be useful. The Mid-American (or Mid-Am) exchange trades grain contracts that are 1,000 bushels as opposed to the larger 5,000 bushels at the CBT. On any given day, there is little to know difference in price between the two exchanges. Therefore, if 5,000 bushel contracts are too large for your purposes, you may want to use the Mid-AM market for 1,000 bushel contracts. In addition to the Mid-Am, there is the Kansas City Board of Trade (KCBT) and the Minneapolis Grain Exchange (MGE). These exchanges specialize in trading different grades of wheat from the CBT's soft red winter wheat. At the KCBT, a hard red winter wheat is traded while the MGE trades a hard red spring contract. Both contracts are 5,000 bushels.

For example, suppose today you sold December Corn futures for a price of $2.75 a bushel. This is referred to as going "short" corn. Anytime between now and December, you can offset this contract by simply buying back the December futures. This will offset your commitment in the futures market. Of course, over that time period the price may have moved lower or higher from the price you went short at of $2.75. If you buy it back at a lower price, then you will earn a profit whereas if you buy it back at a higher price, you will suffer a loss.

As an example, suppose in November you decide to buy back your December Corn futures contract and the price is $2.87 then you would suffer a loss of $0.12 per bushel or $600 on one CBT corn contract. If instead the price falls to $2.65 by November, the purchase of the December contract would result in a profit of $0.10 per bushel or $500 per contract.

The point in using futures contracts is to establish a price for your commodities. We shall see later that by using a futures contract, you will establish a forward price and regardless of whether prices increase or decrease, you will still receive the contracted price.


D. Finding Futures Prices

In today's electronic age, it is rather simple to find futures price information for little or no cost. Most newspapers that maintain a business or financial section will provide futures price information and sometimes option price information for the larger futures markets like the grains and oilseeds. The most comprehensive national newspaper for this information is probably the Wall Street Journal, although other financial oriented papers carry similar information.

Probably the most effective source of information on futures and options prices is over the internet. The Chicago Board of Trade maintains an excellent website with 10-minute delayed futures and options quotes. In addition to the price information, there is a wide array of educational material and market information for the products traded.

To access the CBT website, go to http://www.cbot.com and you can access the market price information from the menu.
If you have a futures account with a broker, you can usually access futures price information from them via an automated telephone service or also possibly through an internet home page.

E. Using a Futures Broker: Accounts and Margins

Because most individuals are not members of futures exchanges the vast majority of the public must trade through a futures broker. A futures broker is simply an individual that handles futures and options transactions for his clients.

There are basically two types of commodity futures brokers depending on the type of service offered. A full-service broker provides trading advice including market outlook information as well as guidance regarding futures or options positions to place. This advice may come through phone calls that will be made to you on a regular or semi-regular basis or via newsletters, faxes or the internet. Sometimes, full-service brokers will call when the market you are interested is moving quickly and they see a need to place an order. While the commission will vary, the usual range is about $50-$100 per round-turn trade (to buy and sell one futures contract).

The second type of futures broker is a discount broker. A discount broker simply provides trade execution without market advice. Unlike a full-service broker, a discount broker will not give you any personal opinions on market direction or strategies but will only take your trading order and handle your account. For this service, you usually pay around $20-$35 per round-turn trade.

Whether you should go with a full-service or discount broker depends on your comfort level with trading. If you have not traded futures or options contracts, a full-service broker may be worth the extra costs because they can provide more advice about strategies than a discount broker. However, this does not necessarily guarantee that the advice that you get from a full-service broker is the correct advice! An important aspect to remember about full-service brokers is that they earn their commission regardless of whether you make money on a trade or not. Therefore, they have a strong incentive to have you make trades. This is true even if the trades they suggest may not be the best for your needs.

If you prefer to make your own decisions and not feel pressured by the advice of your broker, a discount broker may be more appropriate. The disadvantage of using a discount broker is that you must monitor the markets on a regular basis and make your own trading decisions. However, even some discount brokers offer market newsletters or other forms of information which can help you make trading decisions.

Opening A Futures Account
Commodity brokerage firms generally require a client to deposit at least $5,000 to open a commodity trading account. However, because of the intense competition among commodity brokers, this amount can be negotiated down and some brokers will not require any funds until you are ready to trade.

To open an account requires the prospective client to pass a ''suitability'' screening. This means that the prospective client be qualified for commodity trading in the sense that he or she has been appraised of the inherent risks, has sufficient financial resources to trade, and is not disqualified by reason of mental illness or legal constraint.

Usually, one finds that few mature persons who have financial resources beyond the immediate security need of themselves and their families are turned down as being unsuitable. Suitability does not mean that the prospective client has demonstrated any indications of market or trading knowledge likely to lead to profitable trading.

Most brokerage firms now offer money market funds. Therefore, you can open a commodity account and money market account at the same time. Funds are transferred to the commodity account as required. As long as the funds remain in the money market account the earn interest. Excess commodity account funds may be moved to the money market account. This arrangement has the advantage of allowing the trader to meet initial margin and margin calls by simply transferring funds from the money market account to the commodity account.

Types of Orders
To make futures or options transactions requires that you give certain instructions to your broker. These instructions, also known as trading orders, dictate how many contracts you want to buy or sell, the price you are willing to accept on a trade, and the time period you wish the trade to be executed.

The most flexible order is a Market order. This transaction will be executed ''at-the-market'', meaning you will either buy or sell at the prevailing price when the order gets to the trading pit on the exchange floor. Using a market order is good when you want a trade to be executed immediately as it will usually only take 5 minutes or less to have the trade executed after you give your instructions to the broker. The downside of using a market order is the price may be substantially different from the price quoted when the order was placed. This is particularly true in a volatile market situation where prices are moving sharply higher or lower. Other market orders include Market-On Open and Market-On-Close which are to be executed only during the formal opening or closing periods for a trading day.

Of time orders, the shortest lived is the Fill-Or-Kill (FOK) order. If an FOK order cannot be filled when it arrives at the trading pit on the exchange floor, it is canceled. A Day order is the next longer lived order normally encountered. A day order expires at the end of the trading day it is not filled before the end of the trading day. The longest lived order is the Good-Till-Canceled (GTC) order which remains in effect until it is either executed or canceled by the trader. While these orders can be good to keep your order active if the market moves to a desirable price level, it is important not to forget that the order is still in effect. Many brokers will send weekly reminders if you have standing open orders.

To ensure that no more than a certain price is paid to establish a long position, and no less for a short position, a Limit order is used. This is typically stated as ''Buy 5,000 bushels of May Corn at $2.45 or better.'' The ''or better'' phrase allows the order to be filled at the limit price of $2.45 yet does not prevent filling the order at a price more favorable to the trader.

In order to protect a profit, or limit a loss in the event that a trade does not turn out as expected, a Stop-order, also referred to as a Stop-Loss order, is used. A stop order becomes a market order (or limit order) if the price falls to that level for a sale or rises to that level for a purchase. A similar order is a Market-If-Touched (MIT) order. An MIT order also is triggered if a certain price level is reached. However, an MIT order is used to sell at a higher price or buy at a lower price, whereas a stop order is just the reverse.

While these are some of the more important trading orders, it is possible to work out special orders with your broker. When opening an account, ask your broker for a list of acceptable orders so that you may become familiar with the terms and orders that they allow.

Margin Account
With every new futures trade, traders deposit money, called the initial margin, with their broker. This margin serves as a security deposit or performance bond guaranteeing that the trader will abide by the contract terms. Traders must make this deposit whether they enter the market from the long or short side. The initial margin is roughly 3 to 10 percent of the value of the contract although the amount can vary by commodity and depending on how volatile the market price has been of late.

It is important to recognize that the amount of margin money is not the most that can be lost from a futures trade. If you maintain a losing position, you will be responsible for all losses on the contract, even if these losses are more than the amount of initial margin. In fact, your broker will require that you send more money (known as a margin call) when your margin account falls below a pre-specified level, known as the maintenance margin or variation margin. Your margin call would have to be enough to get your account back to the initial margin level.

To illustrate how margin accounts work, let's assume you take a short position in the December corn futures contract at a price of $2.85. After calling your broker to sell the December contract, you would deposit or have in your account enough funds to cover the initial margin (plus commission). Let's assume that the initial margin is $500 for a corn contract and the maintenance margin is $300. Therefore, you would be required to post $500 to take the position and if your margin account ever falls below $300, you would be required to send money to get it back to $500.

Example Margin Account from A Short December Corn Contract
Date	December Corn Price	Profit/Loss	Margin Account
3/5	$2.85		$500
3/6	$2.83	+$100	$600
3/7	$2.92	-$450	$500 ($350 margin call)
3/8	$2.91	+$50	$550

Because futures positions are marked-to-market, profits and losses are paid-up on a daily basis. Profits are added to the margin account while any losses are subtracted from the margin account. On 3/6, the price fell to $2.83 so this resulted in a profit of $100 on one corn contract. This $100 was added to the margin account balance to bring the account up to $600. The following day, the price rose sharply to $2.92 resulting in a $450 loss on the position. Notice that this is the loss in the position's value from 3/6 to 3/7. At this stage, the margin account would have only $150, which is below the maintenance margin level of $300. Therefore, the trader would get a margin call by phone after the close of trading to send $350 to bring the margin balance back to $500, the initial margin level. For the last date on the table, the price fell 1 cent and $50 is added to the margin account to bring the total to $550. Note that even though the margin balance is $50 greater than the initial margin level of $500, the trader has a loss of $300 on this trade because of the $350 margin call that had to be made.

As you might suspect, if the market is quite volatile and moving against your position, you may have several margin calls in a short time period. If you get a margin call, you will be required to have the money wired to your brokerage account and available before the opening of trading on the following day. Thus, it is important to closely monitor your positions on a daily basis so you can be prepared for such a circumstance. Another possibility is to maintain additional funds in your account beyond the initial margin, which your broker could use in the event of significant losses to meet the margin requirements.

While margin calls can create cash flow problems, as a hedger it is important to remember that when you are losing money in the futures market, you will eventually make it up on the cash market. For example, if you sell a corn futures contract and the price increases, you will need funds to cover the losses on the futures contract. However, when you go to sell corn in your local cash market, your local price will be higher and you will receive a higher price. The loss on the futures position and the increase in the cash corn price will usually balance out. To get around the cash flow problem, you should contact your creditor to see if they will provide funds for margined futures trading. Many bankers are happy to provide this because they realize that futures contracts can help assure financial stability and profits.