10.1.2-RISK AND THE RELATION TO TRADE CREDIT-IMPORTANT TRADE ASPECTS AND TERMINOLOGY
Important trade aspects and terminology
Long and short positions.
'Long' means unsold stocks, or bought positions against which there is no matching sale. The total unmatched quantity is the 'long position'. Short is the opposite, that is, sales exceed stocks and one has outstanding sales without matching purchases - the 'short position'. When large holders sell off their 'longs' the market speaks of 'liquidating'. Conversely, when traders buy in against 'shorts' then the reports speak of 'short covering'.
Physical and paper trade
. There are two very different types of coffee trade. Exporters, importers and roasters handle green coffee: they trade 'physicals'. Others trade purely on the futures markets and are known as 'paper' or technical traders because they do not habitually deliver or receive physical coffee. Paper traders include brokers acting on behalf of physical traders wishing to offset risk (hedging), market makers, individual speculators (day traders) and institutional speculators (funds).
Physical traders perform a supply function. Trading physicals requires in-depth product knowledge and regular access to producing countries. Futures traders, on the other hand, trade the risks players in the physical market wish to safeguard against. Most futures contracts are offset by matching counter transactions through the clearing houses that manage the contract settlements of the futures markets and debit or credit traders with losses or profits. Very rarely therefore do futures traders handle physical coffee: instead they specialize in market analysis and trend spotting. Coupled with considerable financial strength this enables them to take on the risks the physical trade wishes to offset by providing market liquidity.
Exporters on the other hand combine analytical ability with product knowledge. Like their clients they can put a value on physical coffee (quality!), and they know which quality suits what buyer. Most paper or technical traders are not very conversant with 'quality', and do not need to be.
When physical traders wish to guard against future price falls on unsold stocks they sell futures, and the paper trade buys those futures contracts. When the delivery time draws near, the physical trade will want to buy those contracts back and the paper trade will then sell them.
Because the clearing house is always between buyer and seller (and deals only with approved parties) the identity of either is irrelevant. The system works because a futures contract represents a standard quantity of standard quality coffee, deliverable during a specified month (the trading position) and so matching trading positions long and short automatically cancel each other out, leaving just the price settlement.
First and second hand.
Coffee sold directly from origin (from producing countries) is first hand - there were no intermediate holders. If the foreign buyer then re-offers that same coffee for sale, the market will know it as second hand. But international traders also offer certain coffees for sale independently from origin: in so doing they are going 'short' in the expectation of buying in later at a profit. To achieve such sales they may actually compete with origin by quoting lower prices. Market reports then refer to second hand offers or simply the second hand. Traders can buy and sell matching contracts many times, causing a single shipment to pass through a number of hands before reaching the end-user: a roaster. Such interlinked contracts are known as string contracts.
Volume of physicals versus futures and second hand.
The volume of physicals is limited by how much coffee is available, but there is no such constraint on the trade in futures or second hand coffee. The huge volume of trade on the futures markets contributes strongly to the volatility of physicals. Futures can cause prices for physicals to move abruptly, sometimes for no immediately obvious reasons. In addition, the volume of trade in some individual coffees regularly exceeds actual production because many second hand or string contracts are either offset (washed out), or are executed through the repeated receiving and passing on of a single set of shipping documents. Producing countries are therefore but a single factor in the daily trade and price movements.
This is the difference, plus or minus, between the price for a given trading position on the futures markets of New York (ICE - previously known as NYBOT, trading arabicas) or London (LIFFE, trading robustas), and a particular physical (green) coffee.
Briefly, the differential takes into account (i) differences between that coffee and the standard quality on which the futures market is based, (ii) the physical availability of that coffee (plentiful or tight), and (iii) the terms and conditions on which it is offered for sale. By combining the ex dock New York or London futures price and the differential, one usually obtains the FOB (free on board) price for the green coffee in question. This enables the market to simply quote, for example, 'Quality X from Origin Y for October shipment at New York December plus 5' (United States cts/lb). Traders and importers know the cost of shipping coffee from each origin to Europe, the United States, Japan or wherever, and so can easily recalculate 'plus 5' into a price landed final destination.
Price to be fixed - PTBF
. Parties may agree to sell physical coffee at a differential (plus or minus) to the price, at an as yet undetermined point in the future, of a specific delivery month on the futures market, for example, 'New York December plus 5' (cts/lb) or 'LIFFE July minus 25' (dollars/ton). The contract will state when and by whom the final price will be 'fixed': if by the seller then it is 'seller's call', if by the buyer then it is 'buyer's call'. See Chapter 09, Hedging and other operations.
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