The purpose of this blog is to explain more about using “one cancels other” or OCO orders on the Riemann wool forward market with a particular focus on the 19 and 21-micron contracts. As part of the blog we will also undertake analysis of the basis between 19 and 21-micron classes to outline the seasonal movement in this basis, including how/why the basis has narrowed over time.
“One cancels other” orders – OCO orders
The Riemann wool trading platform allows for orders to be placed for the same clip across multiple wool categories at different price points in each wool category without the risk of the grower getting set on more than one of the categories. This is because as soon as one leg of the linked order is traded, the Riemann system immediately cancels the other leg of the order. Hence the term OCO order - “one cancels other”.
For example, a grower that will have 5,000 kg of wool for sale in February 2017 can decide to place the following orders in both the 19 and 21-micron categories linked as OCO orders.
19-micron order – sell 5,000 kg at 1450¢ for maturity on 8th February 2017 and,
21-micron order – sell 5,000 kg at 1350¢ for maturity on 8th February 2017.
Assuming the 21-micron order trades at 1350¢ the other side of the order in the 19-micron class at 1450¢ is immediately and automatically cancelled by the Riemann system so the grower doesn’t end up forward selling too much of their expected clip.
The benefit of using these type of OCO orders is that the grower can appeal to a wider group of buyers as the demand across micron categories can sometimes be different and some classes of wool are more liquid than others on the Riemann platform. In addition, it is likely that the 19-micron contract is a better fit for the type of clip they expect to deliver to auction so hedging their exposure using a 19-micron contract will be a better hedge.
The closer the actual micron of the wool sold at auction is to the micron category of the forward sale contract, the more likely the hedge will protect against any adverse price movement. Therefore providing a better hedge of the price risk. So a grower that expects to have 19-micron wool for sale is better to use a 19-micon forward contract if they can. Using a 21-micron forward contract to lock in an exposure to the 19-micron physical wool auction market will only be effective if the 19-micron physical wool auction price movements mirror the movement in the 21-micron wool auction prices over the term of the forward contract.
Consider these two scenarios to illustrate this point.
Grower 1 has 5,000 kg of 19-micron wool to sell in February 2017 and places a 19-micron order at 1450¢ in the Riemann system in May 2016 when the 19-micron auction market is trading at 1500¢. The order is filled during 2016 and when February 2017 arrives the auction market for 19-micron wool is trading at 1420¢. The grower sells his 5,000kg of wool at auction at 1420¢ and collects $71,000. He also collects $1,500 from the forward sale contract (1450¢ less auction settlement price of 1420¢ by the 5,000 kg volume). The net result to the grower is he receives $72,500 for his 5,000kg clip equating to a nett price of 1450¢ as per the original forward contract. A good hedge result.
Grower 2 also has 5,000kg of 19-micron wool to sell in February 2017 and places a 21-micron order at 1350¢ in the Riemann system in May 2016 when the 21-micron auction market is trading at 1400¢. The order is filled during 2016 and when February 2017 arrives the auction market for 21-micron wool is trading at 1340¢. The grower sells his 5,000kg of 19-micron wool at auction at 1420¢ and collects $71,000. However, he only collects $500 from the forward sale contract (1350¢ less auction settlement price of 1340¢ by the 5,000 kg volume). The net result to the grower is he receives $71,500 for his 5,000kg clip equating to a nett price of 1430¢. In this instance the hedge was not as good as grower 1 since the basis between the 19 and 21-micron categories changed during the time frame.
The table below highlights the outcome of these two scenarios for added clarity.
So given the risk of a hedge not always being a perfect match for what happens in the physical auction markets why don’t growers use forward contracts just for the class of micron they expect to deliver?
The simple answer to this has to do with liquidity and participation in the forward market. The 21-micron contract has had more liquidity than the 19-micron class, in recent times, so placing an order just in the 19-micron category could mean a grower misses out on getting set on their price level. Often hedges are not perfect but they can remove most of the price risk. Placing an order in a market that has an imperfect hedge is better than no hedge at all as the grower that didn’t do any forward sale in the scenarios listed above would have ended up with a price of 1420¢ on their clip.
Therefore, using an OCO can allow the grower to take advantage of markets with more liquidity and at the same time have a chance of getting set in a micron category that has less participation but may be a better fit as a hedge to their price risk. However, in order to use these OCO orders effectively it requires the grower, or their adviser/broker, to have a good understanding of the relevant basis between micron categories and how it may change over the course of time.
Basis between the 19 and 21- micron categories
Figure 1 highlights the movement in basis of 19-micron over 21-micron wool since 1991 overlayed with the percentage of the total wool volume that is made up of 19-micron wool and finer, represented by the green shaded area. Clearly, the 19 to 21-micron basis has been more volatile pre 2001 but as the percentage of the clip made up of finer wool has grown the basis has narrowed and the volatility has lessened. The average basis since 1991 has been 213¢ (red line)
Indeed, as shown in figure 2 the basis of 19 to 21-micron wool since 2012 has been significantly narrower than it has been on the longer term perspective and has also been less volatile, usually ranging between 20-100¢ and averaging 55¢ over this time frame.
Figure 3 demonstrates the seasonal movement in basis since 2012 and shows the 2016 pattern in basis (green line) along with the 2015 pattern (orange line). Overlaid on the chart is the seasonal average pattern since 2012 (black dashed line) and the average for the whole period of 55¢ (red dotted line). The light green shaded area represents the normal range in the basis during the season based on the data since 2012. It highlights where the 19 to 21-micron basis has ranged for 70% of the time.
The recent widening of basis toward 95¢ represents a fairly uncharacteristic movement for this time of year based on the variation in basis seen since 2012. Interestingly, there was a widening of the basis during 2015 that peaked near 80¢ before narrowing sharply over winter. During a “normal” season basis should be expected to be near the 55¢ level for this time of year and usually narrows toward 30¢ during July before recovering to 75¢ later in the year.
Figure 4 shows the same chart as in figure 3 but expands the potential range area to show 95% of the historic seasonal variation in basis. The recent movement in basis for the 2016 season above the green shaded band demonstrates how extreme the movement in basis is given the normal seasonal pattern displayed since 2012.
Based on the recent past, the seasonal pattern in the 19 to 21-micron basis tends to narrow over winter. Currently it is trading above 90¢ however as explained it could reasonably be expected to narrow back to a 40-50¢ range into June and July.
Using OCO orders can provide the opportunity to have more than one chance of getting a forward price. This is especially relevant for wool growers with finer clips who have in the past used the 21 MPG contract to access the larger traded volumes in this micron type.
Fortunately, the Riemann Wool Forward system has the capacity to not only provide transparent pricing of the wool forward market, but also allow wool growers and their brokers to place OCO orders and have “two bites of the cherry” when placing forward orders.