What are Futures?

A recent discussion with a potential investor encouraged us to write this article and explain in its simplest form what futures contracts are and who utilizes them. As an investment advisor in managed futures, we overlook the core ideas of how the futures markets started and their purpose.  Prior to understanding what managed futures are as an asset class or how you can invest, investors should be familiar with the underlying commodities being traded on a daily basis and why these markets exist in the first place.

History of the Futures Contract

The futures contract (or forward contract) as we know it today began in the mid-nineteenth century as a way for farmers to sell their grain to mass amounts of people. Farmers from all over the mid-west would travel to Chicago to sell their inventory. This central grain market gave farmers the ability to sell their grain for immediate delivery in what is known as the spot market, or they had the option to sell their grain for a certain price at a future delivery date. This is how the futures contract was born. A futures contract is a legal agreement between a buyer and seller for the purchase or sale of a commodity on a specific date in the future. Today, futures contracts exist not only on agriculture products, but for everything from treasuries to energies, to precious metals…etc. Over the years, futures contracts have evolved to standardize the process in which commodities are priced and bought/sold in the most efficient matter.

What is a Futures Contract?

Who Utilizes Them

The futures markets are broken down into two market segments: hedgers and speculators.  A hedger is an individual or firm who uses the futures markets to offset price risk when intending to sell or buy an actual commodity. A hedger either currently has the physical commodity in hand or intends to have the physical commodity in hand at some point in the future.  An example of a hedger would be a wheat farmer who would like to protect his current crop. Let’s say a wheat farmer that is growing wheat expects the price of wheat to decline in the near future. With that in mind, the wheat farmer has the ability to lock in a price for his current crop by selling a wheat futures contract. Yes, you can sell a futures contract prior to buying it, this is more commonly referred to as short selling. If the wheat farmer sold wheat futures at $4.50 per bushel and wheat prices drop to $4.00 per bushel, the farmer would have a $.50 profit on the wheat futures contract sold, which would offset the $.50 loss he is seeing on his actual wheat. By doing this, the farmer has protected himself from the decline in the price of wheat that could adversely affect his future profit. However, let’s say the price of wheat futures doesn’t decline and instead rises to $5.00 a bushel, the farmer now will be getting more money for his wheat crop but will be losing money on the short futures contract. In short (pun intended), farmers will give up the potential for future profits in order to protect themselves from the potential for losses.  Hedging can be done on any futures contract, just depending on what specific physical commodity you are dealing with.

The other segment that makes up the futures market are speculators. Speculators are individuals or corporations who accept market risk in an attempt to profit from buying and selling futures contracts by correctly anticipating future price movements. Investors that are investing in managed futures are considered speculators. Although the investor is not personally buying and selling the futures contract themselves, they are giving the authority to a Commodity Trading Advisor to buy and sell futures contracts in hopes for a profit on their behalf (PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS, FUTURES TRADING INVOLVES SUBSTANTIAL RISK OF LOSS).

Both speculators and hedgers are crucial to offering the best and most efficient marketplace for everyone. As the futures markets have evolved over the past 100 years, the marketplace has changed and created greater opportunity in markets outside the agriculture space. This efficiency in the futures markets has allowed investors the opportunity to invest with various CTA strategies, providing an uncorrelated diversified asset class. As traditional assets such as Equities and Real Estate continue to gain more popularity, investors utilize futures to add diversification to their investment portfolios.