Of all the futures markets that we trade, by far the ones that have been around the longest are the agricultural markets; specifically, the grains markets. In fact, the reason we have a futures market today is because a bunch of farmers and commercial entities got together to form the Chicago Board of Trade back in the mid eighteenth century. Their objective was to create forward contracts that would allow a farmer (the seller of grains) and a commercial entity (the buyer of grains) the ability to lock in prices for future delivery. The purpose in doing this was to facilitate a way to hedge future prices.
What is a Hedge?
A hedge is simply a mechanism that offsets, or makes up (to put it in layman’s terms), what a farmer would lose in the cash markets if prices in the grains he plants were to drop precipitously prior to harvesting. He does this by engaging in a sale of a contract that expires at a future date. This futures contract would obligate the farmer to deliver the grains he harvested upon the settlement date of that contract for the agreed upon price. Conversely, a commercial, which could be someone like a bread baker or a food producer, would hedge against higher prices by buying, or going long on a contract, at the end of which he has to buy or take delivery of the grains for his business. This is the definition of a forward contract, which coincidentally is where the term ‘Futures’ comes from. This helps the farmer in the event that, say, Corn drops from $10.00 to $ 5.00 a bushel in the time that the farmer went from planting to harvesting. If prices rise, the commercial would benefit from the purchase of that same contract.
Prior to the creation of the Chicago Board of Trade, Farmers and Commercials had no recourse to hedge against the vagaries of the agricultural markets. Hedging is now commonplace across all big business. For example, nowadays, multinational firms hedge currency risk in the futures markets as do airlines in the oil market against higher fuel costs.
All contracts traded on the major futures exchanges are standardized; meaning, they have a specific quantity and quality for every contract. As an example; all grain contracts are traded on the CBOT (Chicago Board of Trade) and are 5000 bushels in size. WTI (West Texas Intermediate) Crude Oil is traded on the New York Mercantile Exchange and controls 1000 barrel per contract, just to name a few. The futures markets are centralized and highly regulated markets.
Commodity markets are priced in the long term, based on the amount of supply and demand established for that market. So, if on any given year the expectation is for a bumper crop (an abundance of grains) and the demand remains static, prices would most certainly fall. The opposite would be true if the crop was compromised in some manner causing a dearth in the commodity, likely causing prices to move higher. Lots of research is done in this arena by large agribusinesses as a way of maintaining their edge.
Additionally, the US Department of Agriculture periodically releases reports on the status of crop production and inventory. This information can be useful as the release of this information can often cause volatility spikes and create opportunities for more experienced futures traders.
For short-term trading, however, the price charts, and specifically the patterns that suggest where the Commercials are buying and selling, are all we need to focus on. This is where we will find our low risk, high probability opportunities in the futures market.
Lastly, because the health of a grain crop can be influenced by weather patterns, some traders will use seasonal data as an additional tool to gauge future price projections. This information can prove to be helpful, provided the data has a large sample size to backup the statistical evidence.
All told, Soybeans, Corn and Wheat are great trading markets and should be explored by all futures traders. I hope this piece gives you small insights into these markets. As is the case with any markets, make sure you understand the risks, margin requirements and trading times before you start trading them.
Read the original article here - Trading the Agricultural Markets