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Simplifying The Futures Market
DR. ANDREW P. GRIFFITH
KNOXVILLE, TENN.
One year ago, this column focused on the topic of “Markets made Simple.” The point of that article was that people tend to make things more difficult than they really are including cattle markets. The same can be said for the futures market. There are a lot of agricultural producers who do not look at the futures market, because they do not understand it or it confuses them. The futures market is really not that difficult, and the purpose of this article is to help folks understand the simplicity of the futures market.
The Chicago Mercantile Exchange (CME) hosts futures contracts for many agricultural commodities such as corn, soybeans, milk, hogs, feeder cattle, and live cattle. This is a short list, but the examples used in this discussion will be feeder cattle and live cattle. However, much of the discussion will pertain directly to other commodities.
The most basic concept of any futures market that needs to be understood is that the market is trying to determine today what supply and demand will be in a future time period which is what determines the price. For instance, there are eight feeder cattle contracts traded each year (Jan, Mar, Apr, May, Aug, Sep, Oct, Nov). Thus, the market is trading contracts for November, and the price for November feeder cattle is based on what the expected supply and demand for feeder cattle will be in November. This means that people trading the November contract today (We are physically in May.) are looking at a large sum of fundamental information such as cattle inventory, cattle on feed, weekly and monthly slaughter, unemployment, disposable income, coronavirus, and a plethora of other information to estimate supply and demand for feeder cattle to be traded in November.
Thus, today’s (May) price projection for November is based on the best information that is currently available. The likelihood the November feeder cattle contract closes in November at the price it is trading for today in May is practically zero, but it provides the best guess market participants have for November at this time.
From a cattle producer’s standpoint, the futures market can be used to make cattle purchase and sell decisions or it can be used to manage price risk of future cattle purchases and sells. This simply means the futures market provides cattle producers a longer window to make cattle purchases and sells throughout the year compare to only operating in the cash market.
Many producers view the futures market negatively because they think it is what causes the local cash market price to go up or go down. The futures market does not make local prices go up or down. Local cash prices do tend to follow the futures market price, but that is because the futures market should be capturing all of the available information concerning supply and demand. Once again, the futures market is being traded by people who are using the best current information to estimate what future supply and demand will be. Thus, the futures market helps transfer information to all participants in the cattle industry as it relates to expectations by others. This is why the cash price follows the futures contract price.
If a person has trouble understanding how the futures market works and how it can be used then the best course of action is to totally forget everything one knows about the futures market and start over. Many people struggle with understanding the futures market because of preconceived notions and their knowledge of alternative price risk management tools. The futures market is simply a tool like any other tool. It has a specific function and use. The futures market can be likened to a pair of fencing pliers, it has several uses but it is not a hammer. If it is used as a hammer then expect it to fail at some point. ∆
DR. ANDREW P. GRIFFITH: Assistant Professor, Department of Agricultural and Resource Economics, University of Tennessee
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