Commodity market

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Swaps difference between physical and financial energy trading exchanges of payments between two parties. They are financially settled and no physical commodity is delivered or received by either party. They represent a substitute for the futures contracts but rely on NYMEX pricing to establish the financial arrangement for the swap contract. It is the price known at the time the deal is struck. The difference between the two represents the amount of payment due one party or the other.

The calculations are the same as those shown in Lesson 9's difference between physical and financial energy trading spreadsheet. The advantage of using Swaps for hedging is that you can achieve the same price protection without actually having to buy or sell NYMEX contracts. In a previous lesson and, in the textbook, we discussed the fact that physical entities wishing to hedge must take a position in the financial market which is the opposite of their physical position.

For instance, a crude oil producer is difference between physical and financial energy trading the commodity. Therefore, in order to execute a proper hedge, they must go "short" in the financial derivative they choose. In Lesson 9, I presented how the physical and financial prices interact in a hedge. Skip to main content. Financial Energy Swaps Print Swaps represent exchanges of payments between two parties. Key Learning Points for the Mini-Lecture: They are strictly financial.

No physical exchange of the commodity takes place. They are a simpler and less expensive way to hedge price risk. In addition, some brokers will give quotes over the phone. The "floating" price becomes known when the NYMEX contract for the particular month settles and the monthly index "postings" we addressed in Lesson 5 for the cash location is published.

This is known as the "actual" or "settlement" Basis and represents the other value in settling the Swap. The following Mini-Lecture is a summary of the points presented above.

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Traditionally, Commodity Futures contracts are settled by physical delivery upon expiration. In addition he will also be responsible for any transaction cost that could include transportation, storage, inspections and insurance. When the Futures exchanges create these Futures contracts another stipulation is the quality and quantity of the underlying Commodity that will be delivered.

This insures whoever is taking delivery of the Commodity that they will know exactly how much and how good the product is. A Corn farmer looking to hedge his crop would figure he gets approximately bushels of Corn per acre an average estimate. He multiplies bushels by 60 acres and gets 10, bushels of Corn. Each Corn Futures contract calls for 5, bushels. The farmer would probably sell 2 Futures contracts to hedge his crop for the year. The exchange also will list the grade of Corn the farmer can deliver.

This Corn will be inspected to make sure it meets or exceeds the grade specification. After the inspection who ever receives the Corn through the delivery process will be assured it is of good quality. Imagine if ranchers did not receive good quality Corn and they fed their livestock with it. I wrote about contango and inverted markets in previous articles.

When looking for these characteristics, make sure the Futures contract is a physical delivery type. The majority of Commodity Futures contracts traded on United States exchanges can be physically delivered. This does not apply to just the Agricultural Commodities. Each Commodity Futures contract will have its own unique specifications. It is important to understand the market you are trading. Here are two links to the most popular Futures exchanges:. That is the process if you actually wanted to have it delivered to you.

You will likely just offset your position by buying back if you sold first or selling back if you bought the contract first. Your broker has all your positions monitored on a risk server and will know anytime you get close to a delivery situation. As time draws near to a First Notice Day delivery situation and you still have an open position your broker will notify you and ask your intentions.

Brokers are responsible for any losses or fees you might cost the clearing firm where you have your account. These losses come out of his pocket, not the brokerage firm. There are some Commodity Futures contracts that do not have a physical delivery.

These contracts are settled in cash. If a Commodity cannot be stored for a long period of time due to spoilage or other logistics the contract resorts to a cash settlement.

Currently there are two Commodities and a Sector that have cash settlement. From its birth a pig takes about 6 months to reach slaughter weight of pounds. When a hog weighs pounds live weight it will yield about pounds of lean pork. The Commercial traders found it was better to hedge this widely used portion of the hog instead of the entire live hog.

Since this lean hog meat cannot be stored indefinitely the exchanges created a cash settlement. Live Cattle are calves to the point when they are about pounds which takes about months from birth. After they reach this weight they are transferred to feedlots where they become known as Feeder Cattle. Here they will remain for about 5 more months until they put on approximately more pounds. At this point they are usually slaughtered and sent to meat processors for packaging.

Leaving the feed lot the average slaughter weight is about 1, pounds. Once Feeder Cattle leave the feedlot there is a storage issue with this Commodity. For this reason the exchange uses a cash settlement process. So now you know which markets are cash settled. But just what does cash settled mean? Does this change the way you view price structure? At the expiration of the Futures contract instead of having to make or take delivery of the physical Commodity your account is either debited or credited with cash.

Each contract has a dollar value when you buy or sell it. Table 1 will show an example of a few cash settled markets. We will examine a Lean Hog trade and how your account will be debited or credited if you held this until the contract expires. Your analysis was correct and the market trended up into the expiration of the contract. On the last day of trading the December Lean Hog contract was trading for Cash settled Futures would look like this in your trading account.

And this would be called a cash settled transaction. If you had a loss they would have removed this amount from your trading account plus a commission fee per contract. Knowing about the markets you trade cannot be emphasized enough. Commodity markets serve a true economic function everyday of our lives. Trading Commodities is not a video game.

If you try trading Futures markets without market knowledge the leverage will surely cause you large losses in your trading account. I would advise you to get as much education and understanding of any asset class you trade before investing your money.

There is more to trading for a living than technical analysis. Disclaimer This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever.

Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.