Most cotton growers are very knowledgeable when it comes to growing and harvesting a crop. They have years of experience, often passed down through generations, and Extension agents, crop consultants and others can fill in the gap.
Using the cotton futures market, farmers can lock in prices (or at least price ranges) and indemnify their investments against falling prices. At the 2007 Beltwide Cotton Conferences in New Orleans, Texas A&M agriculture economics professor John Robinson gave an introduction to marketing that outlined some of the basic definitions and principles of cotton and commodities marketing. The following are excerpts from his lecture:
Standardized Forward Contracts, Futures Markets and Price Discovery
If you are a grower, you are probably familiar with what a forward contract is. It is just where someone comes to you, and you hammer out a deal. You are going to deliver a certain amount of cotton, of a certain grade, to a certain location, and I am going to give you this price for it – all at some point of time in future. But what a simple standardized forward contract doesn’t provide, it doesn’t provide any information to anyone else as far as what cotton is worth in general.
Futures markets began simply to attempt to standardize cotton for those forward contracts. So when people started hammering out futures contracts, they were talking about the same quantity, the same delivery location, the same base quality – so they really allow people to trade “oranges to oranges.”
This may seem simple, but it has major benefits. If everybody knows what the going value of a certain standardized set of cotton is, then you have the benefit of price discovery – people know what cotton at a certain level is worth. So you can make your business decisions, you can decide whether to plant more cotton, you can decide whether to invest in a gin or to buy more equipment. That is the price discovery benefit of futures markets.
Who’s In the Game
Growers, co-ops and merchants all participate in the market – they are all hedging their risk. They are what we called “long” in cotton, because they own cotton and they want the price to remain high to protect their investments. “Long” means you are buying futures contracts; “short” means you are selling futures contracts.
Investor speculator groups also participate in the market. That includes small investors as well as large investors and hedge funds. The value of these groups is that they provide a lot of volume for the farmers who simply want the market to reach a certain level so they can get in and cover their risk and get out.
Contracts – Sign (Not Really) on the Dotted Line
In the cotton exchange, they trade two basic types of contracts: futures contracts and then options on futures contracts, which are derivatives of futures contracts. A future is an obligatory contract; an option is a right, but not an obligation.
An option is more like an option on your house. When you were buying your house or your property, you probably paid some money for the right to consider the deal you were offering that seller. You wanted a little time to consider it, so you paid for an option. You paid for a little time to consider buying that house at a certain price, but that option contract did not obligate you to buy that house.