how's the weather?

Ok, help me out here folks. The merc has futures contracts in a category called "environmental." http://www.cme.com/trading/prd/env/monthftr3671.html
I'm getting confused about the purpose of a futures contract. My understanding of traditional commodities is that an auction market exists, and people transact business at a mutually agreed upon price, and that the trading causes the price to move based upon buying and selling pressure. If the buyers are eager, they chase the sellers and the price goes up. If the sellers get nervous and lose their ability to hold out for a higher price, they lose heart and start to chase the buyers and the price falls. The trading activity changes the value of the commodity.

Now what does this have to do with the weather? How can you trade heating degree days? The value (how hot it is) won't change as the result of trading activity. Have we just slid into betting on a **** fight?

Thanks in advance.
JO

I see that cawkfight is an illegal word.

JumpOff said:

Ok, help me out here folks. The merc has futures contracts in a category called "environmental." http://www.cme.com/trading/prd/env/monthftr3671.html
I'm getting confused about the purpose of a futures contract. My understanding of traditional commodities is that an auction market exists, and people transact business at a mutually agreed upon price, and that the trading causes the price to move based upon buying and selling pressure. If the buyers are eager, they chase the sellers and the price goes up. If the sellers get nervous and lose their ability to hold out for a higher price, they lose heart and start to chase the buyers and the price falls. The trading activity changes the value of the commodity.

Now what does this have to do with the weather? How can you trade heating degree days? The value (how hot it is) won't change as the result of trading activity. Have we just slid into betting on a **** fight?

Thanks in advance.
JO

I see that cawkfight is an illegal word.

Click to expand...

yeah that is true, but why would the buyers of something be more aggressive than the sellers?? because tehy think teh value of the contract will rise....

The HDD and CDD contarcts are mainly used for headging pruposes (i.e a brewery that feels that when the temp falls below a certain level then they loose x% porfit per degree down as people do not want to drink in the cold)....These contracts are derivatives of teh temp, but are also moved by the trade inbalance.....if the buyers are more aggressive than the sellers then the price will move up, hence why its futures contract.....if it was the underlyign then the price wont be affected by the inbalance........dose that make sense (sorry for bad spellign and grammer - bit busy)

I guess the classic example is an ice cream seller and an umbrella maker. They can 'trade' the weather between them to even out their profits. e.g. if it's cold and raining the ice cream seller looses money in his business but makes money on the weather futures (if the weather is worse than usual). The umbrella seller does well selling umbrella's but looses money on the futures. But maybe they should just merge their businesses and cut the 'futures' middle men out.....oh but then the M&A people would have made a mint from the merger.

JO,
I seem to remember someone writing a very good essay about orange traders.
It seems to me that those orange growers would want to "hedge" their future crops with a weather future just in case there was a late freeze, and they lost their crops because of it.
The more likely a freeze might happen, the more orange growers there will be who wished they had bought that future when it was cheaper but now have to pay up to get it.

Now with traditional hedging, a maker of granola bars buys future contracts of oats when the price is low, locking in the price and protecting the company from potential cost increases. The cost of storing the product, or the interest charged for carrying the position through additional months is all manageable and built into the cost of the product - just like paying for insurance.

So do business use these heating degree days and cooling degree days contracts like weather insurance? To hedge against extreme weather patterns that are outside the norm? I mean, there is no reason to buy insurance against the norm, because the underwriters would get your money almost all the time and you would get "the norm," same as if you hadn't paid the premium. People hedge or insure against the risk they can not bear. So if you hedging against the possibility of an outlier, I would expect the contract price to be "more expensive" the further out it is, ie; you are paying for a longer period of insurance coverage? I would also expect the price of the contract to be more and more arbed to reality as the contract nears close?

Thanks,
JO

Another example may be the power plants/ electrical companies in the US as if the weather is going to be v.hot, air conditioning units will be using up more electricity and thus more power.