Wheat Futures and Options

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The Kansas City Board of Trade, established near one of the world's most fertile growing regions, is the largest free market for hard red winter wheat. Prices negotiated in the KCBT wheat futures trading pit are the benchmark for wheat prices around the world.

The role of the KCBT has evolved since the exchange was founded more than 120 years ago as a central market for wheat grown in the Great Plains. The KCBT has become an international market force, influencing wheat prices in Australia and Argentina as well as Kansas and Oklahoma.

The KCBT also became a financial market leader with the introduction of its Value Line stock index futures contract in 1982, and extended its leadership to energy in 1995 with the introduction of western natural gas futures and options. But the exchange has not lost sight of its original purpose: to provide price protection for wheat producers, handlers and processors.

WHO USES KCBT WHEAT FUTURES?

Traders in the KCBT wheat pit typically represent interests that handle and process wheat - producers, exporters, millers and bakers - and whose inventories are subject to price change. They use futures contracts to minimize the risk of price change, a procedure called "hedging."

Speculators also are represented in the KCBT wheat pit. They perform the crucial role in any futures market of assuming risk from hedgers. These investors neither own nor plan to own commodities, but hope to profit from price changes in the futures contracts they buy and sell.

WHAT IS A FUTURES CONTRACT?

A futures contract is an agreement between a buyer and a seller to receive or deliver a product on a future date at a price they have negotiated today.

The agreement is standardized as to delivery period, contract size and quality of the product. These specifications are determined by the exchange.

The only negotiable terms are price and the number of contracts involved in each trade. Delivery of the product seldom occurs. Futures contracts typically are used as a price protection mechanism or an investment tool, not as a method of selling or obtaining a product.

To avoid having to meet his contractual obligation to receive or deliver a product, a buyer or seller must liquidate his futures contract. A buyer (long) would sell his contract, and a seller (short) would buy his contract back. This procedure is called offsetting a position.

The ability to deliver is necessary to maintain the economic relationship between the cash and futures markets.

WHAT IS A KCBT WHEAT FUTURES CONTRACT?

A KCBT wheat futures contract represents 5,000 bushels of hard red winter wheat. The contract is for wheat graded No. 2 according to government standards. The wheat can be delivered in Kansas City or in Hutchinson, Kansas, in March, May, July, September and December.

WHAT IS HARD RED WINTER WHEAT?

Hard red winter wheat, grown primarily in the Great Plains, is one of five classes of wheat produced in the U.S. and is used to make bread.

Hard red winter wheat accounts for around 45 percent of total U.S. wheat production and total U.S. wheat exports. Buyers of U.S. hard red winter wheat in recent years have included Egypt, China, Russia and Japan as well as other countries.

Other types of wheat and their uses:

1. Soft red winter, around 20 percent of U.S. production, used for cookies crackers and pastries;
2. Hard red spring, around 20 percent of production, a higher-protein bread wheat;
3. White wheat, around 10 percent of production, used for noodles and bakery products including flat breads;
4. Durum, around 5 percent of production, used for pasta.

HOW ARE FUTURES PRICES DETERMINED?

The futures price is simply what a buyer is willing to pay and a seller is willing to accept for a product.

Traders shout bids and offers until they agree on the price. This method of trading, called "open outcry," is different from stock trading because transactions can occur only in the open forum of the trading pits.

The KCBT itself does not set prices. The exchange is merely the place where buyers and sellers of hard red winter wheat meet to conduct business.

Bids and offers are based on the traders' assessments of supply and demand factors as well as technical indications of price relationships.

WHAT FACTORS AFFECT SUPPLY AND DEMAND?

Factors that influence supply and demand for U.S. wheat include crop size and crop conditions in the U.S. and other wheat-producing countries, the level of surplus or shortfall, agricultural and economic policies in the U.S. and abroad, worldwide demand for wheat, domestic flour milling needs and the relative strength of the U.S. dollar.

HOW ARE KCBT WHEAT FUTURES USED?

Wheat futures can be used for a variety of price protection and investment strategies.

These include:

• Ensuring a selling price for wheat that has not been harvested or for wheat inventories.
• Locking in a purchase price for wheat that will be needed in the future.
• Profiting from a discrepancy in the usual price relationships between hard red winter wheat and another commodity, between two delivery months of the hard red winter wheat futures contract, or between hard red and another type of wheat.
• Participating in economic trends such as an improvement in commodity prices versus stock prices.
• Protecting uncovered KCBT wheat options positions.

WHAT IS THE PURPOSE OF HEDGING?

The purpose of a hedge is to ensure price protection against adverse market moves. While a hedge limits the potential for loss, it also limits the potential for further profit.

A hedge involves taking a futures position opposite, but equal in size to, a cash position. The price movement of one position tends to offset the other because futures and cash prices tend to move in the same direction. This means that a loss in value of the cash position will be offset by a gain in the futures position.

Hedging merely reduces the risk of price fluctuations that can affect the value of a commodity.

HOW DOES HEDGING WORK?

A hedge involves taking a futures position opposite, but equal in size to, a cash position. For example, a mill with an inventory of 100,000 bushels, a long cash position, may put on a short hedge in KCBT wheat futures.

To put on the hedge, the mill sells 20 futures contracts, the equivalent of 100,000 bushels. (Each contract represents 5,000 bushels; 100,000 divided by 5,000 equals 20 contracts.)

If prices decline, the mill's profit from the futures hedge offsets the loss in the inventory value. If prices rise, the mill will lose money on the futures position, but the loss will be offset by the increased value of the inventory.

An exporter that sold 350,000 bushels to Japan but does not yet own wheat (a short cash position) may put on a long hedge in KCBT wheat futures.

To put on the hedge, the exporter buys 70 futures contracts, the equivalent of 350,000 bushels (350,000 divided by 5,000 equals 70 contracts).

If prices increase, the exporter's profit from its futures hedge offsets the higher prices paid to obtain the wheat. If prices decrease, the exporter will lose money on the futures transaction, but gain from the opportunity to purchase cash grain at a lower price.

Hedging examples can be found later in this brochure.

WHAT IS THE CLEARING HOUSE?

Each exchange has a clearing house, usually operating autonomously, to ensure the financial integrity of each trade.

After a transaction has been completed in the trading pit, the clearing house legally assumes the opposite side of each trade, becoming the buyer to every seller and the seller to every buyer. This allows traders to liquidate their positions without locating the original opposite part to the trade.

The clearing house, through its member firms, acts as guarantor of each contract. This alleviates concerns about the creditworthiness of the party on the opposite side of a trade.

No KCBT customer has suffered a financial loss because of default since the KCBT Clearing Corporation was established in 1913.

WHAT IS MARGIN?

Margin is a deposit of earnest money similar to the performance bond required in some business transactions. The deposit represents an investor's intent to stand good for any financial obligations his futures position incurs.

Both buyers and sellers are required to put up margin when opening a futures trading account. This differs from stock trading, where margin is a down payment on a stock purchase.

Margin requirements for each account are figured daily. If the futures position incurs a loss, an additional margin deposit, known as a "margin call," will be required. Gains in the futures position will be added to the margin account.

Margin deposits are credited to the ultimate profit or loss of a position.

HOW IS MARGIN DETERMINED?

Minimum margins are set by each exchange to protect open accounts. Margin levels are not determined by contract value. Rather, margins reflect price volatility and other risks of holding a futures position. Margins vary according to the type of position (hedge or speculative) and vary with volatility.

Brokerage houses may require margins higher than the exchange minimum.

HOW CAN KCBT TRADING VOLUME EXCEED WHEAT PRODUCTION?

Annual KCBT trading volume - total bushels of wheat that change hands - exceeds typical U.S. hard red winter wheat production several times over.

That's because the term "volume" in futures trading refers to the number of times contracts change hands, not the number of bushels actually under contract. Over time, one contract representing 5,000 bushels of wheat can change hands many times.

For example, Trader A buys one contract, then sells it to Trader B, who then sells it to Trader C. Volume is reported as 15,000 bushels because one contract for 5,000 bushels changed hands three times. But the same 5,000 bushels were involved in all three transactions.

Another figure measures the amount of wheat actually under contract - open interest.

Open interest is the number of contracts that are "open" each day, meaning they have not been offset with an opposite transaction or physical delivery by the end of the trading day.

As of this writing, the record high open interest at the KCBT was 253.8 million bushels at the end of trading on February 2, 1996.

HOW ARE WHEAT FUTURES USED?

THE PRODUCER

Situation:
On April 15, a producer anticipates harvesting 15,000 bushels of wheat in July. September wheat futures, on which his cash price at harvest will be based, are trading at $3.48. He thinks prices will fall at harvest and wants protection from the decline.

Marketing Choice Without Futures:
Sell the wheat at harvest, at the risk prices will have fallen below $3.48.

The Futures Alternative:
THE SHORT HEDGE-

Sell three KCBT September wheat futures contracts at $3.48. (Each contract represents 5,000 bushels; 15,000 divided by 5,000 equals three.)

Results:
DECLINING MARKET

By harvest on July 15, the September wheat futures price has fallen to $3.29. The following shows the results of the short hedge:

Note that in a declining market, the profit from the futures hedge offsets the lower cash price the producer receives when he sells the wheat.

ADVANCING MARKET

By harvest on July 15, the September wheat futures price has risen to $3.60. The following shows the results of the short hedge:

Note that in an advancing market, the loss from the futures hedge is offset by the higher cash price the producer receives when he sells the wheat.

Here are the potential results of the producer's hedge at various price levels:

As the table indicates, the net price received is a constant $3.48. The short hedge protects a selling price against a declining market, but precludes gains if the market advances. With the short hedge, additional returns are relinquished to protect an acceptable selling price.

* Note: These examples do not account for basis or commission fees. Hedge results will be affected by changes in the basis, or the difference between the futures price and the cash price at a specific location.

HOW ARE WHEAT FUTURES USED?

THE COUNTRY ELEVATOR

Situation:
On January 22, a country elevator merchandiser sells 10,000 bushels of wheat to a local feedlot for April 15 delivery. May wheat futures, on which the sale is based, are trading at $3.60. The merchandiser thinks prices will increase because old-crop wheat supplies are tight. He wants to pay the lowest possible price to cover his sale, but does not want to buy the wheat now and pay storage.

Marketing Choice without Futures:
Wait until nearer the April 15 delivery date to cover the sale. Risk paying a higher price to buy the 10,000 bushels.

The Futures Alternative:
THE LONG HEDGE
Buy two KCBT May wheat futures contracts at $3.60. (Each contract represents 5,000 bushels; 10,000 divided by 5,000 equals two.)
Current local basis: -.20*
Current cash price: $3.40

*Basis is the difference between the futures price and the cash price at a specific location.

Results:
ADVANCING MARKET
By April 15, the May wheat futures price has risen to $3.85. The following shows the results of the long hedge:

Note that in an advancing market, the profit from the futures hedge offsets the higher cash price the elevator pays to buy the wheat.

DECLINING MARKET
By April 15, the May wheat futures price has fallen to $3.38. The following shows the results of the long hedge:

Note that in a declining market, the loss from the futures hedge is offset by the lower cash price the elevator pays when it buys the wheat.

Here are potential results of the elevator's hedge at various price levels:

As the table indicates, the net price paid is a constant $3.40. The long hedge protects a buying price against an advancing market, but precludes a lower price if the market declines. With the long hedge, gains from lower prices are relinquished to protect an acceptable buying price.

*Note: These examples do not account for commission fees and assume a constant basis of 20 cents under the futures price. Hedge results will be affected by changes in the basis.

HOW ARE WHEAT FUTURES USED?

SPREADING

Spreading is the simultaneous purchase of one futures contract and sale of another in related commodities or different contract months of the same commodity.

Spreads are traded in the expectation of profiting from a change in the price relationship, or spread, between the two contracts. If the price relationship changes as expected, the subsequent offsetting sale and purchase will produce a profit.

Situation:
For example, an investor may expect corn prices to gain relative to hard red winter wheat prices because a severe summer drought is expected to reduce corn production. Currently, KCBT hard red winter wheat December futures are trading at a 90-cent premium to December corn futures. If his expectations are borne out, the spread between corn and wheat prices will narrow.

The Wheat/Corn Spread:
On June 15, the investor buys one December corn contract at $3.10, and sells one KCBT December wheat contract at $4.00, a spread of 90 cents, premium wheat.

Results:
By July 15, the December corn futures price has risen to $3.35, and the KCBT December wheat futures price has risen to $4.10. The spread has narrowed to 75 cents, premium wheat, and the spread has a profit of 15 cents, as follows:

Note that the profit from the corn transaction more than offsets the loss from the wheat transaction because the spread moved in the expected direction. In spread trading, individual contract price movement (up or down) is irrelevant; profit or loss is determined only by the change in price relationship between the two contracts.

Contract Specifications

Kansas City Board of Trade

Chicago Board of Trade

See Also:
  Grain Futures and Options
  Corn Futures and Options
  Soybean Futures and Options