Trading the Soft Commodity Futures

Futures in soft commodities derive their value from perishables such as cocoa, coffee, cotton, orange juice, and sugar. They are historically among the oldest contracts bought and sold. Trading in this market often involves major risks and is not suitable for everyone. In this article, we'll show you how these futures are traded, what affects their prices, and how you can invest in them prudently.

What Are Soft Futures Contracts?

A futures contract for soft commodities is a standardized agreement for the future delivery of agricultural products like cocoa, coffee, cotton, frozen concentrated orange juice, and sugar at a price set when the contract is entered. These futures are listed on exchanges in the U.S., such as the Intercontinental Exchange (ICE), the Chicago Board of Trade, and the Kansas Board of Trade. They are regulated by the Commodity Futures Trading Commission (CFTC) for quantity, quality, time, and means of delivery. Prices are variable according to the market, and these contracts can be volatile: ICE gives them the highest score in its summary risk indicator.

In general, there are two main types of traders in this and other futures markets:

• Hedgers: These are producers, consumers, and processors of soft commodities who use futures contracts to hedge against price changes that would adversely affect them. Using the oldest form of futures trading, farmers can use futures to lock in a price for their crop, while a food manufacturer might use them to secure a stable cost for raw materials.
• Speculators: These traders participate in the futures market to profit from price changes. They provide liquidity to the market but do not have a direct interest in the physical commodities.

Commitment of Traders Reports

The CFTC publishes weekly Commitments of Traders (COT) reports that market participants use to pick up on trends in soft commodities. This can help you discern whether you want to enter, exit, or take long or short positions in the market. The COT reports, however, don't tell you very well whether the market moves are related to hedging or speculation.

Analysts take the headings in the reports as clues to the amount of speculation in the market, but all they get are that—hints—since a company could be hedging and speculating but still show up under a heading generally read as just one or the other. This has long frustrated researchers looking to find out if there are any correlations between price volatility and the level of speculation in the market. Yet, who is trading these commodities matters a great deal. Here are the categories you'll find in any COT report:

• Producer/merchant/processor/user: Businesses directly involved in the production, processing, or large-scale use of the underlying commodity. (e.g., a wheat farm, a grain milling company, a coffee roaster). These are predominantly hedgers.
• Swap dealers: Financial institutions that act as intermediaries, facilitate trades, and often take on the opposite side of client transactions. Their positions can be a mix of speculation and hedging.
• Managed money: Large asset management firms and hedge funds that trade futures contracts. They are generally considered speculators but can be hedging as well.
• Other reportables: All other traders who have to report their positions since they are above the CFTC's threshold. These traders don't neatly fit into the other categories and can be a mix of hedgers and speculators.

The COTs for soft commodities also include this data:

• Open interest: The total outstanding futures contracts for a specific commodity on a given date.
• Long: Traders holding a long position benefit when the price of the underlying commodity increases.
• Short: Traders holding a short position benefit when the price of the underlying commodity decreases.
• Spreading: A position involving long and short contracts in the same or related markets. This is useful for hedging or arbitrage strategies.

Long/Short ratio

From the data in the COT reports, you can quickly compute the long/short ratio, which compares the relative positioning of different traders by dividing long contracts by short contracts in each category. For example, if the managed money category has 30,000 long contracts and 20,000 short, its long/short ratio would be 1.5 (30,000/20,000).

A rising long/short ratio for a category like managed money indicates speculators are building increasingly bullish positioning by adding more long positions relative to shorts. This suggests they are expecting prices to rise. Conversely, a declining ratio could indicate bearishness. Below, we've taken these and other changes in the COT data to chart different indications they could provide.

Advantages of Futures Contracts

Unlike equities, futures contracts can be shorted on a downtick, which gives market participants greater flexibility. This flexibility allows hedgers to protect their physical position and speculators to take up positions given market expectations.

Because the soft commodity markets are traded at an exchange, the clearing services ensure there's little default risk. This means that the clearinghouse acts as buyer to every seller should a market participant have to default.

Contract Specifics

Although there are other sugar and coffee contracts that trade worldwide, we look here at the specifications found in U.S. soft commodities futures.

Cocoa

Discovered by the Mayans of South America more than 5,000 years ago, cocoa was originally a luxury item and aphrodisiac for the very rich. Today, most of the world's cocoa is grown in a handful of countries: Brazil, Ecuador, Ghana, Indonesia, Ivory Coast, and Nigeria. It is used in everyday foods, from hot cocoa to chocolate.

Cocoa is traded in dollars per metric ton, and one contract is for 10 metric tons. For example, when cocoa is trading at $1,500/metric ton, the contract has a total value of $15,000. If a trader is long at $15,000/M ton, and the markets move to $1,555/lb, that is a move of $550 ($1,500 - $1,555 = $55, and 55 x 10 M ton. = $550).

The minimum price movement, or tick size, is a dollar, or $10 per contract. Although the market often trades in sizes greater than a dollar, one dollar is the smallest amount it can move.

The contract months for delivery are March, May, July, September, and December. Delivery points include licensed warehouses in the Port of New York District, Delaware River Port District, Port of Hampton Roads, Port of Albany, and Port of Baltimore.

Coffee

Coffee was initially discovered in Ethiopia around 850. From Africa, coffee reached the Middle East and into coffee houses. It was these coffee houses that gave coffee its exposure to many travelers, which spread its use outside the Arabian borders.

There are two kinds of coffee: Arabica, which is traded in New York, and Robusta, which is traded in London. Arabica is generally considered a higher-quality bean but tastes different depending on soil and weather patterns. It typically grows best in temperate climates. Robusta naturally resists coffee leaf rust but has a bitter taste.

Coffee is traded in cents per pound. One contract of coffee controls 37,500 pounds of coffee. When the price of coffee is trading at $1/pound, the cash value of that contract will be $37,500 ($1.00 x 37,500 = $37,500).

The tick size is 5 cents per pound, which equates to $18.75 per tick. For example, if a trader were to go long at $1.1000 and the markets moved to $1.1550, he would have a profit of $2062.50 ($1.1550 - $1.1000 = $0.0550, and $0.0550 x 37,500 = $2,062.50).

Given that it's one of the larger contracts in dollar terms, even slight moves in price have a significant impact. Coffee typically has more volatility during the day than other soft commodities.

Coffee is deliverable in March, May, July, September, and December. Delivery points are worldwide in ports like Antwerp, Barcelona, Hamburg, Houston, New Orleans, New York, and Miami.

Cotton

Cotton is a hot weather crop, but it's got universal appeal and can be used all over. It is one of the more influential commodities historically. Discovered more than 5,000 years ago, cotton has played a vital role in the rise and fall of many countries. It was one of America's first cash crops, enabled by hundreds of years of mass enslavement.

Cotton is traded in 50,000-pound contracts. It is also traded in cents per pound, so if the market trades at 53 cents per pound, the contract will have a value of $26,500 ($0.53 x 50,000 pounds = $26,500).

The minimum tick size is $0.0001 or $5 per contract. Therefore, any 2-cent move in cotton will equate to either a gain or a loss of $1,000. When the price of cotton goes over 95 cents per pound, the minimum tick movement will expand to $0.0005 to accommodate the larger daily ranges.

March, May, July, October, and December are the contract months for cotton. Delivery points are in Galveston, Greenville/Spartanburg, Houston, Memphis, and New Orleans, Memphis, locales that aren't surprising given where most of it is grown.

Frozen Concentrated Orange Juice (FCOJ)

Orange juice is a relative newcomer to the commodity markets, though the 1983 movie Trading Places has made trading in it among the best-known for decades. OJ was consumed as fresh fruit juice for centuries because it had a relatively short shelf life and was susceptible to price shocks because of supply disruptions. Frozen OJ came out in the 1940s and quickly became the industry standard.

One contract of FCOJ equals 15,000 pounds. If the market price is 90 cents per pound, the contract is $13,500 ($0.90 x 15,000 pounds = $13,500).

The minimum tick is $0.005, or $7.50 per tick per contract. For example, let's say you buy a contract of FCOJ when the market is at 95 cents and then sell it for $1. You would make $750 in this transaction on the 5-cent move in FCOJ.

Oranges from Brazil and Florida are only deliverable in exchange-licensed warehouses in Florida, New Jersey, and Delaware. FCOJ is most traded in January, March, May, July, September, and November.

Sugar

Sugar cane has a long and storied history spanning thousands of years. The plant is believed to have originated in New Guinea and surrounding Pacific islands about 8,000 years ago, later spreading to mainland Southeast Asia and India. Because of its mass appeal, sugar is among the most heavily traded commodities worldwide by total volume.

Sugar trades in contracts, sometimes known as "sugar No. 11", representing 112,000 pounds of sugar, and is expressed in terms of cents per pound. If the futures price is $0.1045, the contract is $11,704 ($0.1045/lb x 112,000 pounds = $11,704). If the market moves from $0.1000 to $0.1240, that is equivalent to a dollar move of $2,688.

The minimum price movement for sugar is $0.0001 or $11.20 per contract.

Sugar is only deliverable in March, May, July, and October. There are delivery points in each nation where sugar is produced. These include countries all over the world, from Argentina to Zimbabwe.

Steps in Trading Soft Commodities Futures

For trading futures in soft commodities, here are the typical steps you would need to undertake:

Step 1: Learn the basics

• Futures: Familiarize yourself with how futures contracts work. Understand how futures trading involves margin (a deposit you put down) and leverage (borrowed capital), which provides the potential for significant losses and gains.
• Soft commodities: Learn about the specific soft commodities that interest you, whether coffee, sugar or another soft commodity. Research market trends, supply and demand factors, and geopolitical or environmental factors, such as climate change, that will impact prices.
• Trading strategies: You should learn the basics of technical analysis, which uses price charts, historical data, and indicators to identify potential trading opportunities; fundamental analysis, which focuses on supply/demand factors, weather reports, geopolitical events, and other macro factors in commodities; and risk management, such as setting stop-losses and sizing your positions to manage your risk.
  

Step 2: Choose a broker and platform

• Regulated and reputable: Select a futures broker regulated by the CFTC and the National Futures Association and check their background.
• Platform and tools: Assess the trading platform's ease of use, order types, and technical analysis tools offered.
• Fees and commissions: Compare the fees and commissions charged by different brokers.

Step 3: Open an account for trading:

• Application: Complete the necessary paperwork and disclosures.
• Funding: Deposit enough funds into your account to meet the initial margin requirements. Never put in more than you can afford to lose.
• Practice: Many brokers offer demo accounts where you can practice trading with simulated funds.

Step 4: Analyze the market:

• Develop a strategy: Use technical analysis, fundamental analysis, or a combination of both to identify trading opportunities.
• Review the present market: Review market reports, weather forecasts, and other news that can affect soft commodity prices.

Step 5: Place your orders

• Market vs. limit orders: Choose between buying/selling at the market price or specifying a desired price.
• Contract details: Carefully select the correct contract symbol, expiration month, and order quantity.
• Duration: Specify if the order is for the day only or will carry over.

Step 6: Monitor your positions

• Track your trades: Keep an eye on your open positions and the market price of the commodity.
• Adjust when necessary: Modify orders or close positions, if needed, based on your strategy and market movements.
• Manage risk: Use risk management tools like stop-loss orders to protect your capital. Staying disciplined and sticking to your trading plan to manage risk effectively is important.
  

Step 7: Settle and close your positions

• Roll over contracts: If you want to maintain a position near expiration, you'll need to roll over into the next contract month.
• Exit: If, instead, you're ready to exit a trade, you can either offset your position by taking an opposite position or wait for the contract to expire.
• Hold until expiry: If you hold the position until expiration, you may need to settle in cash or take physical delivery, depending on the contract specifications.

Soft commodities futures trading carries significant risk. It's essential to thoroughly understand these risks before engaging in trading.

The Bottom Line

Trading soft commodities is perhaps the oldest form of investing. It's still a major business, offering potential gains and protection against inflation. Moreover, there are many different prospects in the soft commodities market. However, high volatility is often marked because of supply and demand dependencies, posing several potential risks for those trading futures. Hence, it requires a well-planned strategy and prudent risk management.