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