In a world of futures and options, sometimes it can be confusing as to what they are, how to use them and where they differentiate from cash markets. I’m often asked to explain agricultural futures and options and recently launched a new educational course on this topic.
Why are agricultural futures and options on futures so popular?
Agricultural futures and options offer many benefits to market participants, but perhaps the greatest of these benefits is liquidity. So, what is liquidity? There are many definitions, but I’ll define liquidity as the ability to enter or exit a position in agricultural markets quickly, efficiently and, most importantly, at a “fair” price.
Price transparency distinguishes futures and options from cash markets.
With futures and options, commercial hedgers as well as speculators know exactly what fair value is for corn, soybeans or live cattle virtually 24 hours a day, seven days a week and 365 days a year. We call this universal knowledge of fair market value, “price transparency,” and it is a by-product of liquidity enjoyed by futures and options traders.
Because you can efficiently place trades in agricultural futures and options markets virtually 24 hours a day, all market participants know the fair value of agricultural futures and options markets and this price transparency fosters even greater levels of liquidity.
Why are futures and option contracts so successful at fostering liquidity?
The key to futures and option contracts being successful at fostering liquidity is standardization. Unlike agricultural cash market contracts, every contract is “standardized” in futures and options. This means that the quantity, quality and physical delivery location, as well as physical delivery dates, have already been determined by the futures exchange on which that contract is traded. Because these contracts are standardized, it fosters liquidity for that single point of price discovery.
For example, corn futures contracts traded on CME Group are always 5,000 bushels, the futures contracts always expire on the business day prior to the fifth calendar day of the contract month, the deliverable quality for the futures and options contracts are always #2 yellow and physical delivery location is always at designated shipping districts along the Illinois River between Chicago and St. Louis.
The two types of market participants in futures and options: speculators and commercial hedgers
Standardized contracts and the liquidity that standardization brings attracts both speculators and commercial hedgers to the futures and options markets. The commercial hedger is a participant who seeks the liquidity and transparency of futures and options in order to protect themselves from the risk of adverse future price movements in the cash markets.
The other type of participant in agricultural futures and options markets is the speculator. The speculator takes on the risk which the commercial hedger is laying off. The speculator participates in these markets in hope of generating a rate of return greater than the risk-free rate given by a short-term instrument such as a treasury bill or LIBOR. Speculators provide the liquidity needed to attract commercial hedgers to the futures and options markets and their liquidity in turn attracts other speculators to these markets.
So, as you can, see futures and options are all about liquidity.