Expiring contracts present a danger

If farmers needed an illustration of the dangers of getting caught in an expiring futures contract, the market just gave it to them.

As the May ICE Canada canola futures contract went into its final days, its price left the cash market far behind and rose dangerously into its own realm.

“There’s always the risk of fireworks if somebody is on the wrong side,” said Agri-Trend Marketing adviser Brian Voth of Altona, Man., about the wild behaviour of May canola futures, which began in the last week of April.

“The May contract was a broken contract at that point.”

Broker Errol Anderson of Pro Market Communications had the same view. 

“Big gainers, big losers: that’s the danger of a front month.… A few players are left and some of them are putting the boots to the others.”

A complicated process takes place when futures contracts, which are always tied to specific expiry dates, begin to wind down. Options contracts based off the futures contract expire, triggering possible moves by options players in the futures market.

People who have bought futures contracts can “stand for delivery” on the first notice day, triggering actual, physical deliveries of grain or the purchase and sale of physical grain already in store.

Anyone with open positions can find it hard to close them because most contract users will have closed their own positions and “rolled” to the next contract.

Few players are left and surprising things can occur.

It’s what most in the markets say happened with the May contract, although there are many theories about what actually took place. 

Somebody appears to have aggressively bought long May futures, driving its price far higher than what could be explained by any move in the cash or other contract months.

Until the last week of April, the May contract had held what seemed to be a sensible $5-$10 per tonne discount to the July contract. This provided carry in the market, which rewarded farmers for holding canola on the farm.

However, the May contract then suddenly surged compared to July, reversing the discount into a premium with jolting, wide intraday price swings and heavy volume, while open interest collapsed.

Jon Driedger of FarmLink Marketing Solutions said one danger of expiring futures contracts is that they can seem to be stable and then go wild. 

“There was big carry (between May and July) all year, the fundamentals to justify it, then all of a sudden you’ve got this really wacky spread action,” said Driedger.

Analyst John De Pape of Farmco in Winnipeg said such explosive action unconnected to the cash markets is a “technical delivery market event” and a unique phenomenon created by the remaining long and short position holders of the contract.

“You never really know all the details,” said De Pape.

“It’s just a few players at the end.”

However, he said the situation highlights the danger to market players, especially small ones like farmers, of playing in the markets without professional help.

He uses swap contracts with a major financial firm to avoid those risks. They are futures price-based contracts that are wound up before the futures expiry period dawns.

Driedger said farmers using brokers and advisers usually get calls a week or two before the expiry period appears. It’s a call a farmer should take and heed.

“A good broker is going to keep you out of trouble,” said Driedger.

Some farmers use discount brokerages, but Driedger said those who use futures contracts without broker advice must pay close attention to risks such as the one that hit the May contract to avoid being caught on the wrong foot.

“Online (discount brokerage) is cheap and it’s pretty easy, but unless you’re watching the stuff and you know what you are doing, (there are many risks).”

Analysts and brokers say futures are a generally safe way to hedge risk, but hedgers should always close their positions before the technically challenging expiry period begins.

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