Help me understand commodities please

I am trying to understand the basics of commodities but the web only has info on trading them which I am not interested in. Here is my question-

Using corn as an example - When is a futures contract written-After is is produced and ready for shipping or before it is produced? What happens if it can"t be produced or delivered due to a catastrophe? Does the farmer need to make good? What if they don"t have the money to make good?

Please excuse the simplicity of my questions and thanks in advance for educating all of us.

Contracts are written before production. They always have a time as well as a strike price. If you cannot deliver, you have to make up the difference on the spot market at current prices. If you don't, your broker will do so.

It does not happen that someone cannot pay. You are not allowed to buy the contract without sufficient funds to cover a potential loss, and they do monitor the situation and will sell you out long before you are in over you head.

Foghorn gave you a really good answer. My 2 cents, using your corn example. Today, I can either buy or sell a corn contract. If Im a cattle feeder I may buy one, as a corn grower I may sell one. The contract is written for me to make or take delivery at some future date. We make a deal and its done. In many cases the farmer, and always the speculator, doesnt actually make or take delivery of the physical contract. He simply buys or sells the opposite position just before the due date.

If I sell a 6.50 a bushel corn contract and the corn market is 6.00 at delivery then I sell my physical corn for 6.00 and buy a 6.00 corn contract to cancel my sale making the 50 cents back on the contract. If however the market is 7.00 at delivery I make the 50 cents on my physical corn and lose 50 cents when I have to buy the 7.00 contract to cancel my sale. In either case, I've guarenteed my sale price.

What eats peoples lunches are shorts and margin calls. If I bought that sold that 6.50 contact and corn goes to 7.00 I have to have money on deposit to cover that 50 cent spread. Over many contracts and with no physical goods to cover the sale margin calls can get big quick. Thats what ruined the Hunts in silver back in the early 80's. They couldnt cover their margin calls and the exchange began to liquidate their positions at a loss driving down the market even more. Shorts, as you mentioned are the same situation. You still have to cover the loss. If you are making physical delivery you have to buy it and sell at a loss. If you are making paper delivery then you lose on the contract spread. If you are in the money you arent necessarily wiped out, out of the money and with no insurance and you take a big financial hit. Some of the major players who make or take physical delivery have a force majeur clause written. This typically costs extra but covers them from having to make physical delivery, but they still have to take the paper loss.

Thanks Foghorn.

Does this apply to the farmer as well? Does he need a broker in order to SELL a contract on his corn? In case his corn crop fails- Does he need sufficient funds to cover a loss? If so, a total crop loss would mean he would need to have 100% funds in his account, no?

Thx

I am not a farmer nor am I in the corn belt. Don't know what goes on between the grower, the elevator, and the feed buyer or exporter. I am guessing that any of the parties can lock in a future price directly with any of the others. The opposite party can offset his risk by going to the Chicago Mercantile Exchange through a broker.

Here in the Northeast during the summer, home owners can lock in their next season's heating oil costs directly with their fuel dealer. He, in turn, will offset any distributor fuel hikes through the New York Mercantile Exchange.

There is a fourth party here and that is the Govt. They provide crop guarantees and/or corp insurance. Many crop losses are reimbursable. I am guessing the Govt will be writing many checks to farmers located along the Mississippi and many of its tributaries. Your county Ag agent should be able to offer specific advice to you regarding your crop.

One should also understand that much of the action, or "open interest" on the commodity exchanges is from parties who will never deliver or receive product. This action comes from speculators placing "educated" bets. The turnover in paper contracts (called derivatives) only produces "price discovery" but that is an important part of any market.

Other derivatives are called "options" on futures contracts. Deposits are not necessary for "puts" and "calls". Dealer only takes a commission. You can buy or sell either a put or call for a total of four ways to do business. Actually there are many more ways when you get into spreads and straddles between delivery months, strike prices, and two different commodities. Many trades only last seconds or minutes and are put on to "scalp" a few dollars per contract. The strategies are endless and are frequently done automatically with a computer program.

Crop insurance will not be writing very big checks to those who lost crops in the MO. bootheel. Went to a meeting in Sikeston last week. 60% of the farmers in that area have CAT ins. at best they will get 30 to 40 % of what a good crop would have made them, maybe not even that much. Cat is 50% of their 10 year APH yield, and 60% of the set price.

Gene

Fargo there are many versions of this best to read a book. Examples You buy a call at $3 per unit for Nov 1 And the price of the unit is 3.50 You can buy the unit for the $3 Another one is you contract a commodity for 5 bushel in the spring and in the fall it is selling for 4.50 You made out but lets say its $6 in the fall you lose. (it will take you a long t time to figure all this out in great detail an investment book may help)

'Here' you can go to any coop grain elevator and they will have several types of contract. It can be possibly 2 years into the future, or it can be next month. So yes, well before the crop is in the ground can be done.

In the right (or wrong) market conditions these contracts cost 'someone' a lot of money to hold until they come due. Perhaps your buyer will take care of that, and perhaps you will need to kick in along the way. Look up 'Margin Calls'.

There are many other ways to sell - Price Later, Hedge to Arrive, oddball stuff with a low price set but allows to go higher by delivery time, etc.

The types of futures you see bought & sold on th Chicago Board of Trade are for the Big Boys to play, with big contracts. However, local elevators and local feed buyers will offer these sorts of contracts to individual farmers ona smaller scale.

If you cannot deliver your crop, you need to work it out with whomever you agreed to the contract with. You _did_agree to bring them the grain and ultimately they can hold you to that, but most all the time you can buy your way out of the contract (price difference between 'now' and when the contract was written plus maybe 10 cents extra) or roll the contract into next year for a penalty/handling fee. If you know you can't make your contract, talk to them early! If you give them time to adjust to the shortage of grain, they will be much happier to work with you.

--->Paul