Welcome to the first of a 3-part series on corn pricing! Yes! Over the past couple of weeks, current events taking place in the country’s heartland have perked my ears to issues surrounding global commodity trading. The thing is, the more I read, the more in the dark I realize I am. What follows, in true Eating Goodly style, is a really barebones look at all these subjects. My aim isn’t to close the book on them, but to allow others in a similar boat as me (the “embarrassingly uninformed” boat) to open that book.
To begin understanding the price of corn, you’ve gotta know where it’s traded. I’m not talking about the produce aisle or the farm-stand… I’m talking about the winner-take-all, no-holds-barred arena known as the futures market.
What Are Futures?
Futures trading came to be about 150 years ago in response to an aggravating commodity market. Commodity sellers were sick of the fickle demand for their product: if a farmer overestimated how many people would want to buy his corn, he’d be stuck at the market with a ton of crops that would end up going to waste. On the other end, commodity buyers were irritated by the changing price of crops: when that farmer would return to the market the next week, he’d be charging his customers twice the original price to recoup his previous losses. Both parties wanted a way to plan better for the future. Hence, they agreed on contracts of future prices for set quantities of commodities. That way, the farmer would know exactly how much corn to bring to the market next week and the buyer would know exactly how much it would cost.
Though the futures market began out of practical necessity, today it operates parallel to the actual purchasing of commodities. In other words, in the futures market you don’t buy bushels of corn, you buy promises of bushels of corn. You speculate on what the future price will be, “locking” it in for the future. Eventually, when it’s time to actually get that corn, its purchased in the cash market and it’ll most likely go for a different price than what you thought you locked in earlier. That’s where speculation comes in – whatever money you made (or lost) by betting on the futures market will offset (or add to) the actual cash price.
To illustrate this point, let’s say you run a beach-front taco truck during the summer. Before the season begins, you want to figure out what the costs of running your truck will be – so in January you purchase a contract in the futures market, setting the price for a bushel of corn at $5. The thing is, by the time you actually need to buy that corn in May, the price has gone up to $6. “What!?” you’ll cry, “This is outrageous!” Cool it… though you’ll still have to shell out a full 6 bucks to buy the corn, with the dollar you earned in the futures market, the net cost of the purchase will even out to the original $5 promise.
This disconnect between the futures market and cash market is significant in that you don’t need an intent to buy the actual commodity to make money from its speculation. In the scenario above, a taxidermist, a bus driver, and a professional wrestler would make the same dollar the taco-maker would from speculating in the futures market. The difference is that, while the latter would see the dollar as a way to hedge future risk, the first three would just see it as money in the bank.
Why Are Futures So Risky?
As financial markets go, futures trading is a risky way to make a buck. Why? Because the cost of entering a deal (the margin) is only a fraction of the promised investment. Let’s say the standard margin for corn is 10%. That means that to buy a promise of 500 bushels of corn at $5 each (total value of $2,500), you’d only need to fork over 250 bucks. If the market’s moving in your favor, this means quick money – a 10% jump in the price of corn (+ $250) translates to a 100% gain on your investment. But let’s say the price of a bushel drops from $5 to $4.30 (-.70 x 500 = – $350) – not only would you have lost your entire initial investment, you’d be out an additional 100 bucks!
Compare this to the inherent risk of the stock market. Because the buy in is 100% of the share price, the only way to lose everything on a stock investment is if that company declares bankruptcy. It’s risky, but it’s not nearly as volatile as futures trading.
Now, there are some measures in place within the futures market to control this volatility, known as leverage. For one, unlike the stock market, which can rise and fall as drastically as the market dictates, futures can move only in predetermined tiny ticks. Let’s say our corn example could only move at ticks of a quarter of a penny – speculating on 500 bushels means every tick would be a gain or loss of $1.25… not too crazy. A second line of defense is trading limits, which literally shut down trading if a commodity price has risen or fallen past a predetermined amount. While these practices do keep the floor from falling out under commodity traders, they don’t negate the fact that – for better or worse – the futures market is a volatile place to stand.
*To read more on futures trading, check out Investopedia.com. You’ll find the articles behind almost everything you just read and a lot more.