Lessons from the Pros


Will the Real Front Month Contract Stand Up, Please?

When trading Futures we have several different events to deal with that Equity traders do not when it comes to charting prices.  Equity prices trade continuously with no disruption to their prices unless they are delisted from the Exchange, a stock split, are acquired by another company or move to another Exchange to trade on.  Futures contracts on the other hand have to deal with contracts on physical Commodities that expire on fixed dates.  There are numerous situations that arise from this, but in this article I would like to address another area that the Commodity Futures trader needs to be aware of.  Futures contract months that are listed to trade, but not necessarily the one a speculator wants to be trading in.  It’s during this time of year when this problem is really obvious in the Grain markets, however other markets have this issue too.

Let’s start with why some Commodity contracts have different expiration months than other Commodities. All Commodity Futures contracts have numerous months trading at the same time.  Let’s look at some months in the CMEGroup Exchange Corn contract:

  • September (U)
  • December (Z)
  • March (H)
  • May (K)
  • July (N)

These are the deliverable months available for the Corn Futures contract.  Every year this is the cycle of expiration months.  At the same time there are multi-year months trading too.  For example we are currently trading December 2012 contracts and at the same time there are 2013 and in some cases 2014 contracts for December delivery trading simultaneously.  Each month in the above cycle has this same multi-year cycle.

During each of these months the contract will expire and there will be a settlement price created on the last trading day of the contract.  This price will be used to inform Commercial users of the product what they will pay to take delivery or get paid to make delivery of that particular Commodity for this contract month period.

When the Exchanges create these contracts they are done so knowing exactly what time of the year a particular Commodity will be in more demand than at other times.  Looking at our Corn contract example we see that many of the contracts are available in early spring, this is traditionally the planting season for crops. This time of year many ranchers (End User) have begun placing livestock (Hogs and Cattle) and since the grass in pastures has not grown yet they will need to have Corn to feed their livestock for a couple of months.  The other contract months we see in September and December are used for the harvest season. This will allow Farmers (Producers) to hedge the typically higher prices in the spring for delivery during these months. During the fall season crops are harvested and brought into the grain elevators for the farmers to receive payment for their crop.  Not all farmers bring their crops to the Grain elevators at this time every year.  Some choose to store the new crop for future delivery which they feel will be priced slightly higher than at the harvest season.  Much more supply comes to market at harvest time and this puts downward price pressure on the cash crop.

The September contract month in Corn is usually not a heavily traded contract and is normally skipped over by speculators and hedgers alike.  By skipping over I mean that once the July contract rolls over the volume does not go into the next contract, September, like many other Futures contracts would.  Instead the majority of volume goes directly to the December contract.  The reason for this is that during the spring when producers were hedging their crop they knew the crop would not be harvested until October or early November.  This would make hedging in the September contract a risk because the crop would not be available for delivery and if they were not hedged coming into the December delivery time there is always a chance of an early frost that could damage their crops.

Table 1 will show the current volume and open interest for the Corn contracts as of this writing:

Contract Month & Year Volume Open Interest
Sept 12 76,018 346,812
Dec 12 160,699 535,369
Mar 13 16,710 139,557
May 13 4,286 26,340

Table 1

The September contract does have volume trading, but you will notice how the majority of volume and open interest resides in the December contract.  The professional and commercial traders are trading the December contract.  The September contract is primarily driven by speculators.

Another market to look at is the Soybean Meal market.  Just like the Corn market this Commodity has certain times of the year where there is more demand than others.  These are the available contract months for delivery:

  • August (Q)
  • September (U)
  • October (V)
  • December (Z)
  • January (F)
  • March (H)
  • May (k)
  • July (N)

Soybean Meal is used mainly in the winter time to feed livestock that are in feedlots.  Soybean Meal is high in protein and can add weight to livestock quicker than just Corn or hay.  While livestock are being kept in feedlots they are exposed to extreme cold temperatures.  This leads to shivering and the livestock can lose weight due to this, the Soybean Meal helps to get the livestock to the needed weight quicker and then they are shipped out.  Also, Soybean Meal cannot be stored like other Commodities because it has a very short storage life so it must be used quickly.

Table 2 will show us the Soybean Meal contracts and their respective volume and open interest:

Contract Month & Year Volume Open Interest
Aug 12 23,497 27,996
Sept 12 17,660 44,706
Oct 12 5,876 24,667
Dec 12 47,260 110,325
Jan 13 2,150 9,386

Table 2

Just like we saw in the Corn contract there are months that appear to be Front Months, but the volume is open interest in the December contract.  This makes December the Front Month for this Commodity at this time.  The other months are disregarded.  The true demand for this Soybean Meal comes in December when feedlots will need to purchase large sums for their herds.  Since Soybean Meal cannot be stored for long periods they must take delivery to as close to the time they need it as possible.  This does not mean they have to pay the cash price at the time they will need the product.  The feedlots will be able to purchase these contracts much earlier in time and take delivery at a much better price.

Many new Futures traders are used to trading the Financial Futures.  Those contracts always have the majority of the volume and open interest in the first contract listed except during rollover time for the last 5-7 days of the life of the contract.  Physically delivered Commodities are different and you should be aware of this.  As speculators it is important that we trade contract months that have the most volume so we have the liquidity needed to enter and exit our trades.

“Success consists of going from failure to failure without loss of enthusiasm” Winston Churchill

Don Dawson

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.