What’s Up With That?
Newcomers to the commodities markets usually don’t know what to make of the price discrepancies between identical futures contracts calling for delivery in different months. The reason is that the more distant futures contracts have higher prices than those calling for delivery this month or next.
It costs more to store copper, silver, cattle, orange juice, pork bellies or virtually any commodity. Costs include storage, insurance, interest, and in some cases, feed (as in the case of cattle futures). Here again we see the carrying charges, and these charges have a direct influence on futures prices.
How This Works
Here’s an example to illustrate my point. Let’s say you’re a hog farmer who wants to sell some inventory soon. You can sell a futures contract calling for delivery in June or August. Unless the price of the August contract exceeds the price of June by an amount equal to the carrying charges, to compensate for feeding costs, etc., you would sell a June contract.
Long-term contracts usually sell for more than near-term futures, and the difference almost never exceeds the carrying charges. For example, if carrying charges are 2 cents per month, August hogs would sell for 4 cents more than June. But the price of the August contract cannot exceed the June price by more than 4 cents.
Let’s say the difference widened to 5 cents. What would happen?
A knowledgeable hog farmer would buy some hogs today and immediately sell an August futures contract for 5 cents more than his purchase price. Since it will only cost him 4 cents to bivouac and feed his hogs for two months (the carrying charges), he has guaranteed himself a 1-cent profit.
In an efficient market, large commercial hog farmers do the same thing, driving the price difference down if it widens to more than the carrying charges.
Commodity Option Prices
Commodity options control futures contracts; and futures contracts, in turn, control physical commodities. With options, however, your risk is much less than with futures, which is why many people prefer them. But how much do you make if a futures contract rises above a call option’s strike price?
Commodity options are different than stock options. With stock options each contract controls 100 shares of stock. Of all commodity futures options, only the 100-ounce gold contract is the same as stock options. Many commodity futures contracts, including those on cattle, hogs, copper and coffee, are priced in cents per pound. The value of a 1-cent move in a given contract differs from commodity to commodity, because each contract is for a different size or quantity of the underlying commodity.
For example, a coffee contract covers 37,500 pounds, making a one-cent move worth $375, while a copper contract covers 25,000 pounds, so a penny move is worth $250. Wheat, corn, oats and soybeans are priced in cents per bushel, usually with a 5,000-bushel contract, so each 1-cent move equals $50.
As you can see, there’s a lot to learn when dealing with options on commodity futures. Once you learn the terms of contracts and what factors drive specific markets, you’ll discover why many people find trading options on commodity futures an excellent way to make big profits.