futures prices as speculatorsattempt to estimate the direction and speed of future price increases. On January 21, 1980, gold prices reached an all-time highof $850 per ounce, but retreated to a record low on June 21, 1999,of $252.90. The older high price record was surpassed in March2008, when the gold futures contract moved above $1,000 perounce, to quickly retreat by June 2008 to about $850. These pricesreflect absolute dollar values; the previous highs of the 1980s weremuch higher when adjusted for inflation.Figure 12-1 shows price levels as of December 2007 for theApril 2008 gold 100 ounce contract.
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SilverAfter gold, silver is the most widely used precious metal. Its attributes include the highest electrical conductivity of any element. Themajority of silver is mined as a by-product of mining for other metals, notably gold, copper, lead, and zinc.Silver has also been popular as a metal used in coinage, jewelry,and tableware. Major world producers are Peru and Mexico. In2005, Peru mined one-seventh of all the silver mined worldwide.Peru’s production in 2006 was 102.6 million ounces, followed by
204
Classifications of Futures
FIGURE 12.1. GOLD (100 OZ.)—APRIL CONTRACT
Source: Charts provided courtesy of TradingCharts.com: http//futures.tradingcharts.com; created with SuperCharts by Omega Research 䉷 1997.
Mexico (92.3 ounces), Australia (77.4 ounces), and China (64.7ounces).Grades differ based on use. Well-known sterling silver contains92.5% silver and 7.5% copper. An alternative, Britannia silver, hasa higher silver content at 95.8%; this is used widely for productionof silverware and wrought plate products. The metal is also used tomanufacture musical instruments and as an amalgam for dentalfillings and crowns. The high conductivity of silver makes it popular in the manufacture of electrical and electronic goods as well,including printed circuits, which use silver paint, and computerkeyboards with their silver contacts. Silver is the most popularmetal used in solder and brazing, as well as in silver-zinc and silvercadmium batteries.As a currency, silver has been the most popular metal of choice
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205
for many centuries. The words for ‘‘silver’’ and ‘‘money’’ are identical in more than 10 languages, and in Great Britain the unit ofcurrency, the pound, is derived from the original value base of onetroy pound of sterling silver. Investors can purchase silver coins or100 ounce silver bars.Silver also has a history in medicinal uses. Before the inventionof antibiotics, silver compounds were used to prevent infections,for treatment of severe burns, and in wound dressings. Today, silver compounds are found in many remedies. However, excessiveuse of silver in medicines has caused cases of argyria in which theskin turns bluish-gray. Other possible side effects such as comahave also occurred.Figure 12-2 shows the 5,000 ounce silver contract for March2008 as of December 2007.FIGURE 12.2. SILVER (5,000 OZ.)—MARCH CONTRACT
Source: Charts provided courtesy of TradingCharts.com: http//futures.tradingcharts.com; created with SuperCharts by Omega Research 䉷 1997.
206
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Classifications of Futures
CopperCopper is a required nutrient for all life forms and, even though itis found in the bloodstream of humans, high levels can be poisonous. This element is valuable for electrical and heat conductivityand is used in many building materials. High reserves of copper inthe United States have kept prices fairly low, and Chile also holdshigh reserves of copper. Mining in the United States has been active since the early 1700s. The oldest operating copper mine in theUnited States is in Vermont. The Elizabeth Mine (The ‘‘Liz’’) wasclosed in 1958. Significant mining continues today in Utah, Nevada, and Tennessee.Construction uses of copper include piping for water suppliesand heating systems; copper wire use in electrical systems; and forlead-free solder. The Statue of Liberty contains nearly 180,000pounds of copper. It is also used in shipbuilding and in the manufacture of waterproof roofing material and rain gutters. In technological applications, copper is replacing aluminum as the metal ofchoice for integrated circuits. Cookware and flatware often areconstructed of copper. Sterling silver, used for flatware, containscopper as well.Coinage has used copper as an alloy or alternative to silver.Currencies in Europe (the Euro), the U.K., Australia, and NewZealand all use copper. In the United States, copper is among themost popular metals, notably in the penny and nickel (the U.S.nickel is constructed of only 25% nickel, and 75% copper).Figure 12-3 shows the March 2008 futures contract for highgrade copper as of December 2007.
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AluminumA major advantage to industrial, aerospace, and transportation usesfor aluminum is its exceptional resistance to corrosion. Aluminumis among only a few metals that retains its luster in powdered form,making it valuable for use in paint. It is also in demand for electricaland electronic uses, as an effective thermal and electrical conductor.Although the most abundant metallic element on earth, alumi-
Precious Metals
207
FIGURE 12.3. COPPER (HIGH GRADE)—MARCH CONTRACT
Source: Charts provided courtesy of TradingCharts.com: http//futures.tradingcharts.com; created with SuperCharts by Omega Research 䉷 1997.
num is rare in free form. This explains the popularity of aluminumrecycling. Scrap is melted for reuse, a process taking up only 5% ofthe energy required to mine new aluminum. Aluminum productioncosts include 20% to 40% of the cost spent in electric power. Soaluminum is very expensive to extract. Major smelting countriesare China, Russia, Canada, the United States, South Africa, NewZealand, and Australia. China produces one-fifth of the total worldsupply. The metal is widely used in aircraft production due to itshigh strength-to-weight ratio, and it is formed into alloy with copper, zinc, and silicon as well as other elements.In addition to use in aircraft, aluminum alloys are used in themanufacture of automobiles, railway cars, ships, and bicycles. It isalso a primary packaging material used to make cans and foil. Inconstruction, aluminum is popular for production of windows, siding, and doors. Additional uses include cookware, household wir-
208
Classifications of Futures
ing, and electrical transmission lines. In its purest form (99.9%),aluminum is used to make CDs and DVDs.One important drawback of aluminum alloys, when comparedto steel, is a high fatigue factor. Aluminum alloys will fail eventually,so that aluminum products have a limited life. These alloys are alsoheat-sensitive, and will melt easily. Operations like welding andcasting are difficult and lead to internal stress.Figure 12-4 shows the March 2008 contract as of December2007.Note the large downtrends occurring at two points in this chart.Both concluded with RSI dropping beneath 40, a clear signal thatthe contract was oversold.
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Platinum and PalladiumPlatinum is a heavy, malleable, ductile metal highly resistant to corrosion. It is widely used in jewelry, electrical contact equipment,
FIGURE 12.4. ALUMINUM—MARCH CONTRACT
Source: Charts provided courtesy of TradingCharts.com: http//futures.tradingcharts.com; created with SuperCharts by Omega Research 䉷 1997.
Precious Metals
209
dentistry, auto emissions control devices and catalytic converters,spark plugs, as a catalyst in fuel cells, in watchmaking, and in laboratory equipment.Platinum is very rare, estimated to be 30 times more rare thangold. South Africa is the world’s leading platinum miner, accounting for 80% of the world supply. Second- and third-place producers are Russia and Canada. In 2006, the total world supply wasonly about 7 million troy ounces; U.S. futures prices rose stronglyin the last half of 2007, mirroring the rise of gold prices during thesame period, and prices of many other precious metals.Figure 12-5 shows the April 2008 contract as of December2007. The price rose steadily, reaching approximately $1,550 perounce. By the following month, platinum prices rose to record highlevels, up to $1,634.50 by January 25, 2008.Note that although prices rose strongly, the RSI remainedunder 80, indicating that the price was reasonable for this contractand was not overbought.FIGURE 12.5. PLATINUM—APRIL CONTRACT
Source: Charts provided courtesy of TradingCharts.com: http//futures.tradingcharts.com; created with SuperCharts by Omega Research 䉷 1997.
210
Classifications of Futures
Palladium is a rare metal very similar to platinum in structure.It is most often mined as an extraction by-product of copper andnickel ores. It is a viable alternative to platinum because its value isone-third to one-fourth of platinum’s per-ounce cost.The top world producer is Russia, which mines more than halfof the world supply. Other countries mining palladium includeSouth Africa, the United States, and Canada. It is used widely inelectronics, soldering, catalytic converters, and in the manufactureof jewelry, as well as in dentistry, watchmaking, spark plugs, andsurgical instruments.Figure 12-6 shows the March 2008 contract for palladium asof December 2007.Note the bottom at the start of December accompanied by veryhigh volume, and a dip in RSI below 40—and then a reversal andprice increase to the end of the month.FIGURE 12.6. PALLADIUM—MARCH CONTRACT
Source: Charts provided courtesy of TradingCharts.com: http//futures.tradingcharts.com; created with SuperCharts by Omega Research 䉷 1997.
Precious Metals
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Chapter 13 continues the discussion of futures contracts witha look at imports and tropical products.
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Notes1. www.lbma.org.uk, link ‘‘about the fixings’’ on ‘‘statistics’’ page.
C H A P T E R
1 3
IMPORTS ANDTROPICAL PRODUCTS
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ommodities that are imported from other countries, also called‘‘tropicals,’’ may be quite volatile due to global effects of interestrates, currency exchanges, and geopolitical events. This chapter describes and analyzes four primary imports and tropicals—coffee,sugar, orange juice, and cocoa.
CoffeeAmong beverages of choice, coffee is one of the most popular. Thisis true not only in the United States, but worldwide. The early success of companies like Starbucks and smaller, more localized retailers and roasters has made coffee more popular than ever. As ofearly 2008, McDonald’s began installing coffee kiosks in many ofits retail food outlets, competing head to head with more expensiveStarbucks locations. The popularity of coffee is unlikely to fall offat any time in the near future. About 1.6 billion cups of coffee areconsumed every day worldwide. Even with the popularity of softdrinks, coffee provides about 54% of caffeine intake.Coffee beans are imported from Africa, Southeast Asia, theMiddle East, and South America. By the year 2000, 6.7 tonnes of212
213
Imports and Tropical Products
coffee were produced per year, and by 2010, the number is expected to rise to 7 tonnes. Among exporters, Brazil is the largestcoffee producing country, with Vietnam second and Columbiathird. Four companies well-known in the United States buy abouthalf of all coffee produced annually. These companies are Kraft,Nestlé, Procter & Gamble, and Sara Lee. This high volume of demand provides a healthy floor for coffee production, and althoughdifferent blends are in use by smaller sources of demand, the highvolume of use provides stability in the coffee market. Futures trading has also been affected by fair trade labeling, providing guarantees to coffee growers of negotiated minimum prices. Fair tradecertification is widely believed to have had a positive impact on bothproducers and consumers.Coffee takes three to five years from planting to harvest, whichat times causes imbalances in supply and demand. Farmers tend toplant when coffee prices are high, even though the lead time untilharvest is so long. Production levels have grown steadily at morethan 2% per year since the 1970s. The International Coffee Organization (www.ico.org) and the National Coffee Association(www.ncausa.org) provide statistics about the coffee market andtrends among producing countries and coffee consumption.The International Coffee Organization reported that for 2007,the three major producers accounted for more than half of worldwide production in 2007. In thousands of bags of coffee, thesewere:Country
Bags (in thousands)
Percent
BrazilVietnamColumbiaAll otherTotal
33,74015,95012,40053,776115,866
29%141146100%
Each bag of coffee weighs 60 kilograms, or about 132 pounds,so these totals represent significant production and exporting activity worldwide. Two varieties dominate the market. About 60% ofall coffee is arabica, a premium coffee bean with a rich brewedtaste. This serves as the benchmark for coffee pricing worldwide,
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Classifications of Futures
based on its quality. The remaining 40% is robusta, which is lessexpensive. Coffee futures contracts are traded on the New YorkBoard of Trade (NYBOT) and involve arabica prices only. The distinction is important because of price differences. The coffee futures contract is properly called Pure Arabica Coffee.Figure 13-1 shows the March 2008 contract as of December2007.The trading range at this time was between 120 and 140 (percontract size of 37,500 pounds), a range that has held for the pastdecade. However, prior to 1998, prices were far more volatile, andwent as high as about 300 briefly. The volatility of coffee prices isat the mercy of weather and the long planting-to-harvest time.
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SugarTwo major varieties of sugar are traded through futures contracts.Sugar 11 is raw sugar produced worldwide, and sugar 14 is
FIGURE 13.1. COFFEE—MARCH CONTRACT
Source: Charts provided courtesy of TradingCharts.com: http//futures.tradingcharts.com; created with SuperCharts by Omega Research 䉷 1997.
Imports and Tropical Products
215
raw sugar produced only in the United States. It is widely used notonly in good and food preparation, but also in industrial applications. Sugar futures are the second most actively traded commodityon the NYBOT. Sucrose (also known as table sugar) is producedfrom both sugar cane and sugar beet. It can be dissolved in water toform syrup, and dissolved sugar is widely used in foods. Worldwideproduction exceeds 134 million tonnes. Cane sugar is produced inwarm climates, and major producers include Brazil (30 million tonnes per year), India (21 million), China (11 million), as well asThailand, Mexico, and Australia (about 5 million tonnes each).Beet sugar can be grown in cooler climates such as northern Japanand parts of the United States.Because the United States has set high prices for importedsugar as a means of domestic price supports, many countries havebegun using corn syrup in place of sugar. Sweeteners like glucosesyrup used in beverages and candy can also be derived from wheatand corn. Artificial sweeteners are used in many soft drinks as well.These trends threaten traditional markets for sugar, and as tradecompetition dominates the market due to climatic differences between producing and consuming nations, the trend toward seekingsugar alternatives will probably continue. The United States is notthe only country that subsidizes domestic sugar production. TheEuropean Union and Japan practice this too.The World Trade Organization (www.wto.org) ruled in 2004that many of the tariffs and artificial price supports practicedworldwide were illegal. The EU responded by cutting sugar prices39% and doing away with all sugar exports. Further reforms intrade practices are likely to occur into the future. A small portionof specialty grades of sugar are designated as ‘‘fair trade’’ commodities. However, competition by region has caused a price war in theform of premiums offered to smaller farmers, and a series of sugarprotocols. The U.S. Sugar Program and the ACP (African, Caribbean, Pacific) Sugar Protocol (www.acpsugar.org) have offeredpremiums of $400 per tonne above world market prices. Meanwhile, the Sugar Association (www.sugar.org) has begun a campaign promoting sugar use over artificial substitutes.These international competitions and price wars make sugarfutures trading interesting and volatile. Politics certaintly affects
216
Classifications of Futures
sugar prices, and the United States continues to impose a quota onimports. This keeps domestic sugar prices well above worldwideprices, and as with all artificial price supports, may cause a shakeout in the future.Figure 13-2 shows the March 2008 contract for sugar 11 asof December 2007.
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Orange JuiceThe primary orange juice futures contract in the United States istraded in the form of frozen concentrate, and is called Frozen Concentrated Orange Juice (FCOJ). The juice is pasteurized prior tofreezing. There are three forms of juice:1. Reconstituted single-strength orange juice is sold as a ready-todrink form sold in bottles or cartons without requiring refrigeration.
FIGURE 13.2. SUGAR 11—MARCH CONTRACT
Source: Charts provided courtesy of TradingCharts.com: http//futures.tradingcharts.com; created with SuperCharts by Omega Research 䉷 1997.
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217
2. Not-from-concentrate juice is pure-form juice. It is pasteurizedand processed and none of the water content of the juice is removed.3. The FCOJ juice has to be defrosted and reconstituted beforeuse. This is the form of juice traded on the futures market. Sinceoranges are perishable, the frozen form is advantageous becauseit can be stored and transported.Oranges grow in many countries. However, only two locations—São Paulo, Brazil, and Florida—have processing facilitiesable to handle a large volume. These two locations dominate themarket, with over 90% of world orange production. It takes anorange tree three to four years between planting and the first harvest. São Paulo trees average 20 years productivity; Florida’s treesare productive up to 40 years. However, exceptionally hard frostscan destroy trees. In Florida, the additional threat of hurricanesalso poses a serious threat.Florida suffered a hard freeze in 1962, destroying much of theseason’s crop and tree inventory. Up until that time (from the1940s to 1960s) Florida had been the only major world producerof oranges. After 1962, São Paulo began competing with the Florida market. Today, Brazil dominates production, with the UnitedStates producing about half as many tons. Other major producersinclude Mexico, India, Italy, China, Spain, Iran, Egypt, and Indonesia. Germany, Britain, and France also produce oranges, but ona reduced scale due to weather differences with the Florida market.Increased production in Russia and Eastern Europe has made thisregion more competitive with other minor markets, includingJapan, Australia, and South Korea.Figure 13-3 shows the orange juice contract for March 2008as of December 2007.
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CocoaThe most common variety of cocoa is called Forastero, which represents 95% of worldwide production. A second variety, Criollo, isharder and more expensive to produce. Cocoa is not necessarilyprocessed where it is produced, nor does consumption level occur
218
Classifications of Futures
FIGURE 13.3. ORANGE JUICE—MARCH CONTRACT
Source: Charts provided courtesy of TradingCharts.com: http//futures.tradingcharts.com; created with SuperCharts by Omega Research 䉷 1997.
in production or processing countries. The Netherlands is the leading cocoa processor, followed by the United States. Switzerland,Belgium, and the United Kingdom have the highest consumptionlevels.Production levels have grown over the past few decades. In1974, worldwide production was about 1.6 tonnes. By 2004, thislevel had grown to 3.7 tonnes, an increase of over 130% in 30years, according to the International Cocoa Organization (www.icco.org).According to the UN Food and Agriculture Organization, production leaders (in million tonnes) in 2004 were:CountryIvory CoastGhanaIndonesiaNigeria
Cocoa Production (in millions tonnes)1.330.740.430.37
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Imports and Tropical Products
BrazilCambodiaEcuadorOther
0.170.130.090.34
Total
3.60
Cocoa is processed to produce chocolate, cocoa butter,candy, soap, and cosmetics. In the futures market, potential problems include farming problems due to poor education in many ofthe highest-volume regions. Sustainable farming methods inthese areas is one of the major objectives of public/private partnerships sponsored by the World Cocoa Foundation (www.worldcocoafoundation.org). Another issue that has led to worldwide concern is the use of child slavery in the leading producingnation, the Ivory Coast. The U.S. State Department estimatedthat more than 100,000 children were exploited in 2002 in thismanner. This problem has led to a U.S. sponsored Cocoa Protocol, aimed at reducing the U.S. purchase and use of cocoa grownin countries using forced child labor. Today, a certification program is in use, aimed at ensuring that cocoa imported from Africais not produced in this manner.Most of the world’s supplies come from African nations, andan intergovernmental organization, the Cocoa Producers’ Alliance(www.copal-cpa.org), represents the interests of growing countries. The organization’s Web site lists four objectives: exchange oftechnical and scientific data; advance social and economic relationsbetween producing nations; ensure adequate supplies for the market; and expansion of cocoa consumption.The market is limited due to climatic constraints. Cocoa treesgrow only within 20 degrees from the equator, and best conditionsare with temperatures from 66⬚F to 92⬚F. Rainfall must be high aswell, and the combination of shade and humidity is ideal. Thus, thepotential for expansion of the cocoa crop is geographically difficult.Due to the high potential for political unrest in many of the thirdworld countries where cocoa is grown, the futures market forcocoa is likely to experience volatility as events unfold.Figure 13-4 shows the March 2008 futures contract for cocoaat December 2007.
220
Classifications of Futures
FIGURE 13.4. COCOA—MARCH CONTRACT
Source: Charts provided courtesy of TradingCharts.com: http//futures.tradingcharts.com; created with SuperCharts by Omega Research 䉷 1997.
The next chapter departs from commodity futures to explainthe various kinds of futures contracts on financial instruments (interest rates and currency), individual stocks, and indices.
C H A P T E R
1 4
FINANCIAL, INDEX, ANDSTOCK FUTURES
I
n addition to the many different commodities on which futures canbe traded, one very large segment of the futures market is for thenoncommodity areas: financial (interest rates and currency futures), indices, and individual stocks. This chapter explains allthese variations.Commodities are at the center of the world economy, and trading in energy, agriculture, livestock, precious metals, and importsaffects every aspect of life. However, everyone is also subject tothe economic forces affected by international debt, interest rates,currency policies, and actions taken by central banks (including theU.S. Federal Reserve). It would be reasonable to define noncommodity futures as types of commodities. In a sense, stocks andmoney are commodity-like in some of their attributes; and futurestrading in these instruments often works much like futures onphysical commodities. However, because shares of stock, currencyrates, interest, and other financial futures are not physical, it alsomakes sense to treat them separately.Financial-type futures trading has existed only since the 1970s.Today, traders and institutions use financial futures to hedge otherpositions. Institutions and corporations can use interest and cur221
222
Classifications of Futures
rency futures to protect against losses or to augment profits, andmany applications are possible. For example, a company with a lotof overseas business activity may be concerned about currency exchange losses. Using currency futures to protect against that possibility is one practical and common method for protecting netprofits at a relatively small cost. Companies with a lot of cash ontheir books often invest funds in securities for a few months oryears. However, many debt obligations are at risk of declining invalue. Based on ever-changing rates, a bond’s face value may fallto a discount, and losses are possible, especially if the company willneed to liquidate these holdings within the short term. So to protectagainst the possibility of declining value, the long position in a debtinstrument can be hedged with a short position in the same instrument (for example, Treasury notes or bonds). So if the long position’s value falls, it will be offset by a decline in the short futuresposition, so that at the time of liquidation, the short position profitwill offset the long position loss.The intriguing aspect of using short futures to hedge againstlong positions, either in debt instruments or stocks, is that as pricesevolve, the relative values change as well. Because futures declinein value over time, the tendency is to approach zero by the deliverydate. The hedge position ends up creating net gains because of this,regardless of whether the prices of the underlying commodity moveup or down. In comparison, a long hedge (where you buy a longfutures contract to hedge against a short position) is more likely tocreate a loss, also due to the declining value of the futures trade asthe delivery date approaches.These are only examples of many possible hedging and speculative strategies using financial futures. Individuals can also usefinancial futures through options or with futures on stocks, leveraging capital while gaining a controlling position in the underlyingsecurity. The variety of financial futures available expands yourpossibilities for short-term profits, hedging, risk mitigation, andspeculation.
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Interest Rate FuturesAs the name implies, a futures contract for interest rates is based onthe rate assessed or charged by an issuer. Because money supply is
Financial, Index, and Stock Futures
223
constantly changing, rates charged for commercial bonds and government bonds also are subject to auction and to competitive forces.Because the rate of bonds is fixed, the current value of bonds mayalso move at a premium above face value or at a discount below facevalue. This affects the current rate of a bond as well.Interest rates affect the entire economy and may also predictinflation or even recessions. As companies expand operations, theyborrow money and pay competitive rates for long-term debt capitalization. As the federal and state governments fund their projectsand operations, they issue bonds as well. In the futures market,many benchmark interest rates change with time. The Federal Reserve, which is the U.S. central bank, sets reserve requirements formember banks and establishes federal funds and discount rates.Fed member banks function through its open market operations.The Federal Open Market Committee (www.federalreserve.gov/fomc/fundsrate.htm) buys and sells Treasury securities, which alsois the focus of many key futures contracts. There is much more tothe interest futures market, of course. Trading also takes place inmortgage interest rates, for example. The very first interest ratefutures contract began on October 12, 1975, on futures of GinnieMae (Government National Mortgage Association, which createsmortgage pools made up of residential home mortgages, also referred to as the mortgage secondary market).Futures trading exists on both short-term and long-term interest rates. Short-term includes 2-year Treasury notes, the Eurodollar, 30-day Federal Funds rate, and 1-month London InterbankOffered Rate (LIBOR) futures. Long-term futures contracts include 5- and 10-year Treasury notes and Treasury bonds futures.The government-based futures are on instruments issued bythe federal government to fund the national debt and ongoing government operations. So these Treasury bills, notes, and bonds arethe funding mechanism for the entire U.S. government. Government debt instruments come in a range of terms, including 3- and6-month Treasury bills, 2-, 5- and 10-year Treasury notes, andTreasury bonds (these were discontinued in 2001). Even thoughthe long-term bonds—30 years from issue to maturity—have beendiscontinued, the existing bond contracts prior to that time are stillin effect, and active trading in outstanding T-bonds is ongoing.
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Classifications of Futures
There is also an active futures market for the 30-year T-bond futures contract. Figure 14-1 summarizes one of the many interestfutures contracts, the March 2008 contract as of December 2007.
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Currency FuturesThe currency of each country or region changes very regularly, andfutures contracts track values from one currency in relation to another. On any given day, a conversion rate applies. This means thatone unit of currency in one country is worth another amount in theother. For example, the U.S. dollar is equivalent to various othercurrencies. Comparisons to the British pound, the euro, and theJapanese yen as of February 11, 2008 were:
1 USD is worth:currency in USD:
British Pound
Euro
Japanese Yen
0.51318901.9486
.689371.4506
106.640.00937734
FIGURE 14.1. 30-Y