Futures Trading: Seinfeld Style - Part 1
Scott Irwin (a prominent Agricultural Economics Professor at The University of Illinois) cowrote a book with Doug Peterson called, Back to the Futures - Crashing Dirt bikes, Chasing cows, and Unraveling the Mystery of Commodity Futures Markets. As the experts, I lean heavily on their work throughout these Substack posts to isolate some key explanations from the book.
In the second chapter of the book, Irwin & Peterson craft a brilliant yet simplified explanation of a complex market using a well-known cast from the hit-sitcom Seinfeld to describe how the futures market for grain commodities function. They start with the historical framework and dive into the mechanics, starting with the origins of the Chicago Board of Trade.
The city of Chicago’s initial growth during the early 1800’s was largely due to its central positioning. For a foundational understanding of commodities terms, see the previous post: Commodities: A Primer.
In oversimplified terms, futures trading refers the the transformation of the commodity in time. In practice, if a farmer wants to guarantee the price of his crop today as he begins to plant the seeds in the spring and long before the harvest season in the fall, the farmer would look to execute a futures transaction to stabilize the value of the labor today for a guaranteed price in the future.
Prices can change throughout the seasons. This price risk of the crop between the spring and fall is effectively insured by the futures contract, and the liquidity of that contract is underpinned by speculators, all of which is facilitated by the market that connects the buyers and sellers of both the raw goods and their associated financial instruments, aka the futures contracts.
“It [Chicago] became a major trans-shipment point for grain and meat, moving commodities from the midwest to the growing population centers on the East Coast. From this, the middle operator was born. These large elevators [elevator = storage facility] in Chicago made money buying tons of grain in the fall, storing it throughout the year, and dispersing it as needed to companies (and consumers).
Initially, trading took place on Chicago’s street curbs, but this was haphazard and confusing. Traders needed a centralized exchange where they could buy and sell commodities, so the Chicago Board of Trade (CBOT) was born in 1848, boasting an initial 82 members.
The CBOT started as a place where you could find a buyer or seller of corn, wheat, or rye in physical quantities. However, savvy elevator operators soon saw it could be risky to buy corn after harvest to store and sell later because the price might decrease, losing them money.
Operators began using “forward contracts”—the precursor to the futures contract. After the fall harvest, elevator operators might approach a company that, let’s say, buys grain to feed livestock on the East Coast. We’ll call the East Coast company Vandelay Industries for our purposes.
The elevator operator, George, would contact Vandelay Industries by telegraph or letter and say, “I’m buying grain this October. Would you be willing to purchase grain from me now for delivery next may at so-and-so price?” This forward contract would take away the risk of falling prices, guaranteeing George’s elevator will profit from the sale.
These early forward contracts were especially important in dealing with weather-related woes. In the 1800s, winter weather froze rivers and canals and blocked roads, preventing grain from being delivered to Chicago. As a result, most grain deliveries had to wait until the spring thaw. But with all the deliveries arriving at once, supply far exceeded demand, and prices would plummet.”
~ Chapter 2: Daredevils
If you enjoyed this excerpt, I highly encourage you to pick up a copy of the book!