Commodities, from iron ore to
steel to scrap to soybeans to orange juice, are bought and sold
either on an immediate-delivery basis (called the cash, or
prompt, market), or as a contract for future delivery. Through
all stages of the commodity price cycle, futures enable buyers
and sellers to lock in prices, volumes, quality and delivery
Futures, among the earliest
risk-management tools, have been used for almost two centuries
by farmers and processors of agricultural products to mitigate
the huge volatility caused by weather, pests, consumer demand
and transportation issues. Other commodities, such as fuels,
also lend themselves to risk management through futures due to
volatility that often is driven by geopolitical risk or supply
In contrast, ferrous metals--and
steel in particular--have been slower to adopt futures because
temporal effects, such as weather and political upheaval, are
less of a factor, and huge global production volumes create a
buffer against outages, so supply is not easily disrupted
except on a highly localized basis.
The weight and volume of ore,
steel and scrap products drive logistics to fewer, larger
hauls, as well as to large inventories--another structural
hedge against outages, but at the same time a financial risk
due to inventory cost. In scrap, there also has been another
factor working against the use of futures: an asymmetrical
market with a relatively small number of large mills or trading
companies buying from a relatively large number of smaller
scrapyards and other sellers. In any market in which one side
routinely sets terms, there is less need for that side to use
outside risk-management tools.
Futures include two types of
contacts: bilateral and exchange-traded. When most people think
of futures, what comes to mind are exchange-traded contracts
handled through a broker on a large, public, commercial
exchange. But any contract negotiated directly between any two
parties for a year or longer also is a future. As bilateral
deals, futures contracts have long been a staple of the steel
contracts in the steel supply chain are more recent
developments. Contracts for iron ore and, more recently,
hot-rolled coil have become actively traded in volume only in
the past few years. A scrap contract in Turkey has been traded
for several years but it was not useful for North American
buyers or sellers, and last September CME Group Inc. launched a
U.S. scrap futures contract.
To be sure, exchange-traded
futures contracts are just one risk-management tool, and the
use of any such tools--or none at all--is up to a
companys senior management. But it should be an informed
decision that is not overly influenced by ingrained practice or
hampered by lack of understanding.
All futures contracts set a
standard size, value, tick size and price limit. Size is the
number of units of the underlying commodity in the contract.
Value is the size of the contract multiplied by the current
price per unit of the commodity. Tick size is the minimum price
change in a futures or options contract; a tick is
the smallest amount that the price of a particular contract is
allowed to fluctuate. Ticks are usually expressed either in
dollars or in percentages and basis points; just as there are
100 pennies in a dollar, there are 100 basis points in each
Some futures markets impose
limits on daily price fluctuations. A price limit is the
maximum amount the price of a contract can move in one day
based on the previous days settlement price. These
limits, set by the exchange, are intended to mitigate
volatility. Meaningful trends and sentiments can carry on; the
intent is to temper knee-jerk reactions, or overreactions. When
a futures contract settles at its limit bid or offer, the
exchange may decide to modify the limit to facilitate
transactions on the next trading day, which could help futures
prices return to a level reflective of the current market
Buying or selling a contract
means having an open position. Some open positions can be
secured by a performance bond, an amount of money that must be
deposited with a broker to open or maintain a position in a
futures account. Buyers make bids, or what they would be
willing to pay, and sellers make offers of what they would like
to charge. Haggling ensues.
All futures contracts have an
expiration date. Some contracts call for the physical delivery
of the underlying commodity or financial instrument to an
approved warehouse; others simply call for cash settlement.
Every futures contract specifies the last day of trading before
the expiration date. Players must be aware as the date
approaches because liquidity, or activity in the buying and
selling of that particular contract, tends to decline as
traders begin to exit or roll their positions over to the next
available contract month.
The CMEs U.S. Midwest No.
1 busheling ferrous scrap futures contract is traded under the
symbol BUS. The standard size is 20 gross tons, the tick size
is one penny, and there currently is no limit. Expiration is
the 10th day of each month, or the next business day if the
10th falls on a weekend or holiday, and settlement is
financial, not physical.
Recent contract prices have
ranged from $404 per gross ton for April futures--settled on
March 13--to between $385 and $406 per ton for the remainder of
2013, $392 per ton for 2014 and $390 per ton for the first few
months of 2015. Contracts are listed 24 months out.
Market participants are either
hedgers or speculators. Hedgers are usually those with a
position in the physical market for the commodity--a yard or
processor with scrap to sell or a mill in need of raw material.
Hedgers also can be those with a tangential or related interest
in the physical market, such as scrap haulers or customers of
mills using scrap.
Speculators are just that: They
are in the futures market to make money by playing the
direction of the market. In times of extreme price movement,
speculators are often criticized for distorting the market.
That condemnation has been true in some instances, but in many
cases speculators provide the bulk of market liquidity, which
allows hedgers to enter and exit their positions efficiently.
Arbitrage, a similar practice, profits on the difference in
price for the same commodity or investment between different
Market makers are trading
companies that have contractually agreed to provide liquidity
to the markets, continually providing both bids and offers,
usually in return for lower trading fees. Market makers make
money by capturing the spread between bids and offers.
Clearing is the other essential
element to exchange-traded futures. Like a sports referee, it
tries to ensure that everyone plays by the rules. Counter-party
risk is a significant liability, especially in global trading.
Clearinghouses confirm the creditworthiness of both sides in a
deal and facilitate deal execution. The CME owns its own
clearinghouse, which is responsible for settling accounts,
regulating delivery, facilitating the option exercise process
and reporting trade data.
At the end of each trading day,
the exchange sets a settlement price based on the days
closing price range for each contract. Each trading account is
credited or debited based on that days profits or losses
and checked to ensure that the trading account maintains the
appropriate margin for all open positions. The practice of
marking accounts to market helps ensure that each account
maintains sufficient capital to meet margin requirements on a