• Futures and options contracts

    Chapter 4 - Cotton trading - The former NYBOT and now ICE Futures U.S. cotton marketplace


    Futures contracts, descended from forward contracts, have remained basically unchanged in form and function since the founding of the first futures exchanges. Forward contracts are cash market transactions that establish the terms for the actual ownership transfer of the physical cotton at a specific delivery date. The terms of the contract are unique to the parties involved. Forward contracts became possible as information transfer accelerated in speed. A futures contract, however, differs from a forward contract primarily in that it is standardized and, while it has a delivery component, it does not exist primarily to facilitate physical delivery.

    A futures contract is a standardized agreement to purchase or sell a fixed quantity of a commodity at a predetermined price, with settlement to take place at a future date. The only negotiable element of the contract is the price. The trading of cotton futures, therefore, involves pricing cotton. Unlike forward contracts, delivery of futures contracts seldom takes place; the difference between the agreed and spot price at the time of contract expiration is typically settled through a cash transaction.

    An option on a futures contract grants the right, but not the obligation, to buy (call options) or sell (put options) a futures contract on the commodity at a prearranged price (the ‘strike price’). For this contract, the buyer or seller of the option has to pay a price at the time of contracting which is called the ‘premium’. In effect, an option contract provides a kind of price insurance.

    Although the institutions and the governing rules and regulations behind the contracts have evolved considerably over time, the concepts behind futures and options contracts and the purposes they serve remain largely unchanged. Futures markets are created to serve cash market needs and therefore seek to reflect cash market conditions. The exchange’s capability to adapt contracts and trading procedures in response to changing industry practices and conditions accounts for its long-term survival and its continuing ability to serve the underlying industry.

    Trading ICE Cotton No. 2 futures and options contracts

    In spite of all of the changes in the cash market, the cotton futures market today still provides the same primary pricing functions as ever: price discovery, risk transfer and price dissemination. The world prices its cotton at a premium or discount to the Cotton No. 2 futures contract traded in New York. The unique characteristics of cotton as a plant are revealed in the complex grading standards of the cotton futures contract. In 1887, NYCE implemented the certificate system. Under the system, a certificate stipulating the grades of cotton became good for delivery, passing from hand to hand like a stock certificate.

    This became the standard for recording and guaranteeing the quality of each specific bale of cotton, a measure necessary to ensure the validity of the futures contract as a benchmark for pricing. USDA is the source of grading cotton for certification in the United States. The certificate functions as a kind of ‘currency’ that facilitates the trading of cotton futures.

    The Cotton No. 2 futures contract is for 50,000 pounds (about 100 bales) of certain minimum standards of basis grade and staple length – strict low middling with a staple length of 1-2/32". Contracts are listed for March, May, July, October and December plus one of more of the 23 succeeding months. No origin is specified. The delivery points listed are: Galveston, Texas; Houston, Texas; New Orleans, Louisiana; Memphis, Tennessee; and Greenville/Spartanburg, South Carolina.

    The price is quoted in cents and hundredths of a cent per pound. Daily price limits are applied of 3 cents above or below the previous day’s settlement price. However, if any contract month settles at or above $1.10 per pound, all contract months will trade with 4 cent price limits. Should no month settle above $1.10 per pound, price limits stay (or revert) to 3 cents per pound. In the spot month (contract nearest expiration) there is no limit on or after the first notice day.

    Floor trading hours are 10:30 a.m. to 2:15 p.m. Eastern Time. Electronic trading hours are 1:30 a.m. to 3:15 p.m.

    The primary cotton classing components are colour, length, micronaire and strength. Micronaire is a reading of the coarseness of the fibre measured by its resistance to air passage. Strength is quoted in gram per tex (g/tex). Regarding colour, the contract permits delivery of only ‘white’ grades of ‘good middling to low middling’ and light spotted grades of ‘good middling to middling’. The basic fibre length is 1-2/32" with a minimum of 1-1/32" at commercial discount and a maximum of 1-3/32" at a premium. Any longer staple does not carry a higher premium.

    Industry standards and practices have periodically led to specification changes. The minimum grade of cotton deliverable against the contract was raised to low middling from good ordinary in 1920. A contract permitting southern delivery was introduced in 1929. In 1939 the basis of the cotton contract was changed from 7/8" to 15/16" and raised again in 1953 to 1". Trading in the Cotton No. 2 contract with a 1-1/16" basis was introduced in 1967. In 1974, the basis grade was changed from middling 1-1/16" to strict low middling 1 1/16".

    In recent years the exchange has adjusted the contract specifications to reflect industry practices. Beginning with the May 2003 Cotton No. 2 contract it:

    • Increased the minimum strength requirement to 25 g/tex (from the previous minimum of 22);
    • Allows for price differentials should USDA commence quoting price differentials for cotton with a micronaire level of 4.8 or 4.9 (currently, micronaire readings of 3.5–4.9 are allowed with no premiums or discounts);
    • Established a new ‘age of cotton’ discount applied to cotton delivered on and after 1 January of the second calendar year following the cotton’s year of growth.

    The stability and continuity of the futures market function is based on the standardization of the contracts to reflect cash market conditions and practices.

    ICE continuously monitors the performance of its markets and the changing cash market conditions. Adjustments have been and will continue to be made to the contract as cash market conditions, crop characteristics and industry practices demand. The exchange’s Cotton Contract Committee is charged with maintaining the integrity of the contract. Proposals for new contracts are also considered and evaluated for potential introduction to the market.

    The evolution of the cotton certificate system illustrates how the exchange can change its procedures and practices while maintaining the essential concepts of its primary functions. Today the certificate system still serves its original purpose, but the development of the Electronic Warehouse Receipt (EWR) system has allowed the assignment of ownership of a bale of cotton to move from a cumbersome manual exchange of paper to a completely electronic transfer and record of the transaction. With ever-increasing globalization, the ability to transfer ownership instantaneously via electronic means ranks with the development of the steam ship and the transatlantic cable as a change in the movement of critical market information.

    The cotton industry uses the Cotton No. 2 futures contract as its primary tool to hedge the purchase or sale price of cotton. Hedging is possible because the cotton futures and the cash market have a strong relationship and generally move in tandem over time. In cotton, the basis has particular importance because of the many pricing variables that affect the global marketplace. To establish a successful hedge, the industry user in cotton (as in other agricultural commodities) must calculate and examine the historical basis for the product trading in the local cash market. This basis risk cannot be transferred to the futures market.

    Since the abolition of the gold standard in 1973, all cotton futures contracts, with the exception of India, have been traded in United States dollars. Hedging or speculation in cotton futures in any other currency, therefore, involves unpredictable exchange rates and adds one more element of pricing uncertainty. Currency risk therefore becomes a factor in calculating basis risk. Comparing the movement of the United States Dollar Index® (USDX® futures and options are traded in the ICE financial markets) and the Cotton No. 2 nearby futures contract illustrates how the rise and fall of the United States dollar affects the price of cotton. When the dollar falls, cotton has often risen in price.

    For cotton in the United States, knowledge of basis must be coupled with an understanding of the changeable logistics of government support programmes. A look at the history of cotton futures trading in New York reveals the impact of government programmes. Between 1950 and the early 1970s, NYCE exhibited an extraordinarily low trading volume. This was a direct result of the United States Government’s policy of maintaining large cotton stocks: the Commodity Credit Corporation (CCC) bought and sold most of the United States cotton, thus eliminating the need for cotton hedging by merchants. For example, in 1966, CCC accounted for 73% of cotton carryover. The Government’s interference in the cotton market was so severe that it almost led to the demise of the exchange. In 1966, NYCE traded only 730 contracts – a daily average of 3 contracts.

    The Farm Security and Rural Investment Act of 2002 and its subsequent changes presented cotton hedgers with new challenges and opportunities. Cotton hedgers today rely heavily on the flexibility of options on Cotton No. 2 futures to reduce risk and capture the benefits of favourable price moves. The increased volume of cotton options in recent years has demonstrated their growing importance to risk managers.

    Regular options are available on the March, May, July, October and December Cotton No. 2 futures contracts. The nearest 10 delivery months are listed for trading. For example, in August 2006, options on the October 2006, December 2006, March 2007, May 2007, July 2007, October 2007, December 2007, March 2008, May 2008 and July 2008 contracts were available for trading.

    The successful cotton hedger can utilize a variable mix of futures, options on futures and forward contracts. The cotton futures and options markets provide a number of possible hedging and investment strategies and opportunities. In order to successfully plan and implement a hedging strategy, the risk manager must compile a marketing plan that includes a reliable history of all input costs, risk tolerance, cash flow, seasonal factors, price/profit goals and historical basis. Once the hedging position has been put in place, it should be monitored and adjusted as market conditions warrant. 

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