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  • QA 092
    Question:
    What is meant by 'buying the switch' in the futures market?
    Background:
    Please describe what is meant when a roaster is said to be 'buying the switch', and provide an example.
    Asked by:
    Retail sector company - USA
     
    Answer:

    Switch is the colloquial name for a futures transaction technically known as 'the straddle', but also called 'the spread'. It means the simultaneous buying of one futures position and the selling of another, in the same commodity. For instance, a trader or speculator 'buys a switch' when he buys the New York September 2006 position (KCU06) and simultaneously sells the December 2006 position (KCZ06), thereby going long the one delivery month and short the other.

    The purpose of taking these two different futures positions is to take advantage of an expected change in their price relationship, i.e. the price difference between them. Transactions are made basis the price difference between the positions in question and orders have to be placed stating that difference. For example,  'Buy one Sept/Dec at 400 points' means the price of the December position should be 4 cents (per pound) above September, i.e. a price difference of 4 cents with the forward December future at a premium over the nearer September.

    One would buy this switch if one thinks that the premium of December over September is unusually high, and is likely to narrow. If over time the difference indeed does narrow, for example to only 250 points, then it is worth liquidating the switch and thereby profit from the gain of 150 points per pound. The offsetting transaction is then called 'selling the switch', i.e. simultaneously sell the near position and buy the forward.

    This means that in trading switches it does not matter whether the market as a whole goes up or down! What really matters is the change in the price relationship, the price difference between the two positions. 

    A roaster will use switches for different reasons, for instance for the hedging of physical inventory. A simple example could be as follows: Assume the roaster maintains a stock (inventory) of 375,000 lbs. of green coffee which has been hedged by selling 10 NYKC September 2006 futures. As September 2006 reaches liquidation during the month of August 2006, these 10 contracts must be liquidated (bought in) latest by the last trading day for the September contract. But, this will leave the inventory without protection…

    In order to continue hedging the physical green coffee the roaster then buys the 'Sept/Dec switch'. In so doing he acquires ten contracts September, thereby liquidating the existing short position, while simultaneously switching the hedge to a new short position of 10 December contracts.  If the green coffee is used up during November the short hedge will no longer be needed and the roaster will then simply buy 10 December contracts to offset the 10 he was short.

    Switches are sometimes also used in 'Price To Be Fixed' transactions, for example when price fixing is not desired in the already contracted month. If so a roaster may decide to 'roll over' the fixation to a subsequent futures position, subject of course to the consent of the other party and reimbursement of all additional costs. For a full discussion of PTBF or 'Price To Be Fixed' transactions please see section 09.02 of the Guide.

    Speculators are active participants in the trading of switches as these operations have the advantage of offering lower risks, (but also lower profit potential).  Futures markets usually encourage this type of trade by requiring less deposit (margin) than for straight purchases or sales.

    For more on trade use of futures markets, including arbitrage and straddle operations, please see sections 09.05 and 09.06 of the Guide. NB: Arbitrage usually refers to transactions based on the price difference between different but similar commodities, for example between New York arabica and London robusta futures.

    Finally and purely for information, one small problem with the term 'buying the switch' is that the meaning varies depending on what market one is trading. For coffee and cocoa 'buying the switch' always means buying the near position (in our case September) and selling the forward (December). Selling the switch on the other hand means selling the near (September) and buying the forward (December).  But in some other commodities 'buying the switch' simply means buying the premium price and selling the discount - such differences are purely due to market tradition…

    Posted 03 May 2006

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