Buying (Going Long) Wheat Futures to Profit from a Rise in Wheat Prices

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Contents

Buying (Going Long) Wheat Futures to Profit from a Rise in Wheat Prices

If you are bullish on wheat, you can profit from a rise in wheat price by taking up a long position in the wheat futures market. You can do so by buying (going long) one or more wheat futures contracts at a futures exchange.

Example: Long Wheat Futures Trade

You decide to go long one near-month CBOT Wheat Futures contract at the price of USD 5.7000 per bushel. Since each CBOT Wheat Futures contract represents 5000 bushels of wheat, the value of the futures contract is USD 28,500. However, instead of paying the full value of the contract, you will only be required to deposit an initial margin of USD 3,375 to open the long futures position.

Assuming that a week later, the price of wheat rises and correspondingly, the price of wheat futures jumps to USD 6.2700 per bushel. Each contract is now worth USD 31,350. So by selling your futures contract now, you can exit your long position in wheat futures with a profit of USD 2,850.

Long Wheat Futures Strategy: Buy LOW, Sell HIGH
BUY 5000 bushels of wheat at USD 5.7000/bu USD 28,500
SELL 5000 bushels of wheat at USD 6.2700/bu USD 31,350
Profit USD 2,850
Investment (Initial Margin) USD 3,375
Return on Investment 84.4444%

Margin Requirements & Leverage

In the examples shown above, although wheat prices have moved by only 10%, the ROI generated is 84.4444%. This leverage is made possible by the relatively low margin (approximately 11.8421%) required to control a large amount of wheat represented by each contract.

Leverage is a double edged weapon. The above examples only depict positive scenarios whereby the market is favorable towards you. If the market turn against you, you will be required to top up your account to meet the margin requirements in order for your futures position to remain open.

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Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

What are Binary Options and How to Trade Them?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]

Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

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Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

Buying Wheat Call Options to Profit from a Rise in Wheat Prices

If you are bullish on wheat, you can profit from a rise in wheat price by buying (going long) wheat call options.

Example: Long Wheat Call Option

You observed that the near-month Euronext Milling Wheat futures contract is trading at the price of EUR 146.50 per tonne. A Euronext Wheat call option with the same expiration month and a nearby strike price of EUR 150.00 is being priced at EUR 9.7700/ton. Since each underlying Euronext Milling Wheat futures contract represents 50 tonnes of wheat, the premium you need to pay to own the call option is EUR 488.50.

Assuming that by option expiration day, the price of the underlying wheat futures has risen by 15% and is now trading at EUR 168.50 per tonne. At this price, your call option is now in the money.

Gain from Call Option Exercise

By exercising your call option now, you get to assume a long position in the underlying wheat futures at the strike price of EUR 150.00. This means that you get to buy the underlying wheat at only EUR 150.00/ton on delivery day.

To take profit, you enter an offsetting short futures position in one contract of the underlying wheat futures at the market price of EUR 168.48 per tonne, resulting in a gain of EUR 18.50/ton. Since each Euronext Milling Wheat call option covers 50 tonnes of wheat, gain from the long call position is EUR 925.00. Deducting the initial premium of EUR 488.50 you paid to buy the call option, your net profit from the long call strategy will come to EUR 436.50.

Long Wheat Call Option Strategy
Gain from Option Exercise = (Market Price of Underlying Futures – Option Strike Price) x Contract Size
= (EUR 168.50/ton – EUR 150.00/ton) x 50 ton
= EUR 925.00
Investment = Initial Premium Paid
= EUR 488.50
Net Profit = Gain from Option Exercise – Investment
= EUR 925.00 – EUR 488.50
= EUR 436.50
Return on Investment = 89%

Sell-to-Close Call Option

In practice, there is often no need to exercise the call option to realise the profit. You can close out the position by selling the call option in the options market via a sell-to-close transaction. Proceeds from the option sale will also include any remaining time value if there is still some time left before the option expires.

In the example above, since the sale is performed on option expiration day, there is virtually no time value left. The amount you will receive from the wheat option sale will be equal to it’s intrinsic value.

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Buying Straddles into Earnings

Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

What are Binary Options and How to Trade Them?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]

Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

Grow Your Finances in the Grain Markets

Temperature, precipitation and the changing needs of customers all contribute to the supply and demand for commodities like wheat, corn or soybeans. All of these changes greatly affect the price of commodities, and the grain markets are essential to managing these price swings and providing global benchmark prices. Read on to dig into and learn about the seven major products of the grain markets. (See also: Futures Fundamentals.)

What Are Grain Futures Contracts?

Anyone looking to invest in futures should know that the risk of loss is substantial. This type of investment is not suitable for everyone. An investor could lose more than originally invested and, therefore, only risk capital should be used. Risk capital is the amount of money that an individual can afford to invest, which, if lost would not affect the investor’s lifestyle.

A grain futures contract is a legally binding agreement for the delivery of grain in the future at an agreed-upon price. The contracts are standardized by a futures exchange as to quantity, quality, time and place of delivery. Only the price is variable.

There are two main market participants in the futures markets: hedgers and speculators. Hedgers use the futures markets for risk management and withstand some risks associated with the price or availability of the actual underlying commodity. Futures transactions and positions have the express purpose of mitigating those risks. Speculators, on the other hand, generally have no use for the commodities in which they trade; they willingly accept the risk involved in investing in futures in return for the prospect of dramatic gains.

Advantages of Futures Contracts

Because they trade at the Chicago Board of Trade (CBOT), futures contracts offer more financial leverage, flexibility and financial integrity than trading the commodities themselves.

Financial leverage is the ability to trade and manage a high market value product with a fraction of the total value. Trading futures contracts is done with performance margin; therefore, it requires considerably less capital than the physical market. Leverage provides speculators a higher risk/higher return investment.

For example, one futures contract for soybeans represents 5,000 bushels of soybeans. Therefore, the dollar value of this contract is 5,000 times the price per bushel. If the market is trading at $5.70 per bushel, the value of the contract is $28,500 ($5.70 x 5,000 bushels). Based on current exchange margin rules, the margin required for one contract of soybeans is only $1,013. So for approximately $1,013, an investor can leverage $28,500 worth of soybeans.

Advantages of Grain Contracts

Because grain is a tangible commodity, the grain market has a number of unique qualities. First, when compared to other complexes like the energies, grains have a lower margin making it easy for speculators to participate. Also, grains generally aren’t one of the bigger contracts (in terms of total dollar amount), which accounts for the lower margins.

The fundamentals in the grains are fairly straightforward: like most tangible commodities, supply and demand will determine the price. Weather factors will also have an effect.

Contract Specifications

There are seven different grain products traded at the Chicago Board of Trade: corn, oats, wheat, soybeans, rice, soybean meal and soybean oil.

Similar grain products trade in other commodities markets around the world, such as Minneapolis, Winnipeg, Hong Kong, Brazil and India to name a few.

1. Corn: Corn is used not only for human consumption but to feed livestock such as cattle and pigs. Also, higher energy prices has led to using corn for ethanol production.

The corn contract is for 5,000 bushels, or roughly 127 metric tons. For example, when corn is trading at $2.50 a bushel, the contract has a value of $12,500 (5,000 bushels x $2.50 = $12,500). A trader that is long $2.50 and sells at $2.60 will make a profit of $500 ($2.60 – $2.50 = 10 cents, 10 cents x 5,000 = $500). Conversely, a trader who is long at $2.50 and sells at $2.40 will lose $500. In other words, every penny difference equals a move up or down of $50.

The pricing unit of corn is in dollars and cents with the minimum tick size of $0.0025, (one-quarter of a cent), which equals $12.50 per contract. Although the market may not trade in smaller units, it most certainly can trade in full cents during “fast” markets.

The most active months for corn delivery are March, May, July, September and December.

Position limits are set by the exchange to ensure orderly markets. A position limit is the maximum number of contracts that a single participant can hold. Hedgers and speculators have different limits. Corn has a maximum daily price movement.

Corn traditionally will have more volume than any other grain market. Also, it will be less volatile than beans and wheat.

2. Oats: Oats are not only used to feed livestock and humans, but are also used in the production of many industrial products like solvents and plastics.

An oats contract, like corn, wheat and soybeans, is for the delivery of 5,000 bushels. It moves in the same $50/penny increments as corn. For example, if a trader is long oats at $1.40 and sells at $1.45, he or she would make 5 cents per bushel, or $250 per contract ($1.45 – $1.40 = 5 cents, 5 cents x 5,000 = $250). Oats also trades in quarter-cent increments.

Oats for delivery are traded March, May, July, September and December, like corn. Also like corn, oats futures have position limits.

Oats is a difficult market to trade because it has less daily volume than any other market in the grain complex. Also its daily range is fairly small.

3. Wheat: Not only is wheat used for animal feed, but also in the production of flour for breads, pastas and more.

A wheat contract is for delivery of 5,000 bushels of wheat. Wheat is traded in dollars and cents and has a tick size of a quarter cent ($0.0025), like many of the other products traded at the CBOT. A one-tick price movement will cause a change of $12.50 in the contract.

The most active months for delivery of wheat, according to volume and open interest, are March, May, July, September and December. Position limits also apply to wheat.

Next to soybeans, wheat is a fairly volatile market with big daily ranges. Because it is so widely used, there can be huge daily swings. In fact, it is not uncommon to have one piece of news move this market limit up or down in a hurry.

4. Soybeans: Soybeans are the most popular oilseed product with an almost limitless range of uses, ranging from food to industrial products.

The soybean contract, like wheat, oats and corn, is also traded in the 5,000 bushel contract size. It trades in dollar and cents, like corn and wheat, but is usually the most volatile of all the contracts. The tick size is one-quarter of a cent (or $12.50).

The most active months for soybeans are January, March, May, July, August, September and November.

Position limits apply here as well.

Beans have the widest range of any of the markets in the grain room. Also, it will generally be $2 to $3 more per bushel than wheat or corn.

5. Soybean Oil: Besides being the most widely used edible oil in the United States, soybean oil has uses in the bio-diesel industry that are becoming increasingly important.

The bean oil contract is for 60,000 pounds, which is different from the rest of the grain contracts. Bean oil also trades in cents per pound. For example, let’s say that bean oil is trading at 25 cents per pound. That gives a total value for the contract of $15,000 (0.25 x 60,000 = $15,000). Suppose that you go long at $0.2500 and sell at $0.2650; this means that you have made $900 ($0.2650 – 25 cents = $0.015 profit, $0.015 x 60,000 = $900). If the market had gone down $0.015 to .2350, you would lose $900.

The minimum price fluctuation for bean oil is $0.0001, or one one-hundredth of a cent, which equals $6 per contract.

The most active months for delivery are January, March, May, July, August, September, October and December.

Position limits are enforced for this market as well.

6. Soymeal: Soymeal is used in a number of products, including baby food, beer and noodles. It is the dominant protein in animal feed.

The meal contract is for 100 short tons, or 91 metric tons. Soymeal is traded in dollars and cents. For example, the dollar value of one contract of soymeal, when trading at $165 per ton, is $16,500 ($165 x 100 tons = $16,500).

The tick size for soymeal is 10 cents, or $10 per tick. For example, if the current market price is $165.60 and the market moves to $166, that would equal a move of $400 per contract ($166 – $165.60 = 40 cents, 40 cents x 100 = $400).

Soymeal is delivered on January, March, May, July, August, September, October and December.

Soymeal contracts also have position limits.

7. Rice: Not only is rice used in foods, but also in fuels, fertilizers, packing material and snacks. More specifically, this contract deals with long-grain rough rice.

The rice contract is 2,000 hundred weight (cwt). Rice is also traded in dollars and cents. For example, if rice is trading at $10/cwt, the total dollar value of the contract would be $20,000 ($10 x 2,000 = $20,000).

The minimum tick size for rice is $0.005 (one half of a cent) per hundred weight, or $10 per contract. For example, if the market was trading at $10.05/cwt and it moved to $9.95/cwt, this represents a change of $200 (10.05 – 9.95 = 10 cents, 10 cents x 2,000 cwt = $200).

Rice is delivered in January, March, May, July, September and November. Position limits apply in rice as well.

Centralized Marketplace

The primary function of any commodity futures market is to provide a centralized marketplace for those who have an interest in buying or selling physical commodities at some time in the future. There are a lot of hedgers in the grains markets due to the many different producers and consumers of these products. These include, but are not limited to, soybean crushers, food processors, grain and oil seed producers, livestock producers, grain elevators and merchandisers.

Using Futures and Basis to Hedge

The main premise upon which hedgers rely is that although the movement in cash prices and futures market prices may not be exactly identical, it can be close enough that hedgers can lessen their risk by taking an opposite position in the futures markets. By taking an opposite position, gains in one market can offset losses in another. This way, hedgers are able to set price levels for cash market transactions that will take place several months down the line.

For example, let’s consider a soybean farmer. While the soybean crop is in the ground in the spring, the farmer is looking to sell his crop in October after the harvest. In market lingo, the farmer is long a cash market position. The farmer’s fear is that prices will go down before he can sell his soybean crop. In order to offset losses from a possible decline in prices, the farmer will sell a corresponding number of bushels in the futures market now and will buy them back later when it is time to sell the crop in the cash market. Any losses resulting from a decline in the cash market price can be partially offset by a gain from the short in the futures market. This is known as a short hedge.

Food processors, grain importers and other buyers of grain products would initiate a long hedge to protect themselves from rising grain prices. Because they will be buying the product, they are short a cash market position. In other words, they would buy futures contracts to protect themselves from rising cash prices.

Usually there will be a slight difference between the cash prices and the futures prices. This is due to variables such as freight, handling, storage, transport and the quality of the product as well as the local supply and demand factors. This price difference between cash and futures prices is known as basis. The main consideration for hedgers concerning basis is whether it will become stronger or weaken. The final outcome of a hedge can depend on basis. Most hedgers will take historical basis data into consideration as well as current market expectations.

The Bottom Line

In general, hedging with futures can help the future buyer or seller of a commodity because it can help protect them from adverse price movements. Hedging with futures can help to determine an approximate price range months in advance of the actual physical purchase or sale. This is possible because cash and futures markets tend to move in tandem, and gains in one market tend to offset losses in another.

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