Cost of carry spreads, delivery locations, and taking or making physical delivery
COST OF CARRY. On TV, you often hear the term contango. What the heck is that? Sounds like a doctors term to make something easy sound bad, so you will leave it alone. Maybe it's a New York term. We are trading grains, and I'm using grain terms, so from here on, expect cost of carry. Cost of carry is a simple calculation used to establish what reasonably should be the widest price differential that a spread between two calendar months of any grain should trade.
The two primary components of carry are storage and interest.. The exchange has a set maximum fee that can be charged for storage for every given grain. Your banker, or you, have a set minimum fee you will accept for the use of your money for a given period of time. Add those two numbers together, and you have a pretty good idea what full cost of carry is. Lets say your calculated cost of full carry for the March/May rice spread is 29 cents. If the spread is trading 28 cents with a month to go to deliveries, a long hedger would probably be better off buying march, then rolling into May before deliveries, knowing his downside spread risk is only around a penny, while upside benefit is unlimited in a shortage of near term supply.
DELIVERY LOCATIONS. Understanding delivery locations, their proximity to you, and how that can affect basis in your region, provides the educated farmer a valuable marketing timing edge. Those of you located close to a delivery site have surely noticed that basis isn't very exaggerated from the exchange price, especially near actual delivery dates. What about when you are further away? Improper or poorly timed hedging of corn in some northern states, or wheat in Arkansas, can have a huge negative impact on your bottom line.
TAKING OR MAKING PHYSICAL DELIVERIES. For even the above average risk farmer, making physical delivery at the CME is probably out of reach. To deliver at the exchange, you need to be a registered regular location, with all the costs and obligations involved with that registration. However, if you contract with a buyer that is exchange regular, why not utilize his regularity to your advantage. Understanding his hedging decisions, and how short term market movements in the delivery cycle will impact his daily basis bids, gives you a competitive edge on all your neighbors.
Taking deliveries is another matter. Remember our earlier cost of carry calculations? The pool of entities available to take delivery is much larger than those who make delivery. In spot month, (the last two days of the month preceding delivery and the actual month of delivery), all long positions are at risk of taking physical delivery. No one shows up at your house with semis of grain. Your clearing firm will receive delivery notice, and funds will be paid from your firm to the delivering firm. You will receive a shipping certificate, or a warehouse receipt, for the grade and grain specified in the delivery notice. If you are just looking to earn interest, not necessarily a big deal what those terms are, but if you want the physical, these details are the game changer. Want to export beans, and someone delivers you #1 located in Chicago? How about wheat with a higher amount of vomitoxin than you want? Or oats with a little lower test weight? These details help dictate how long the delivery line is, and who is in it.