Preface: See part 1 and 2 first, as this article relies on definitions & discussions from those articles.
Why were futures contracts created?
Tracing the origin of investments known as futures would direct one to the mid 19th century, when Midwestern wheat farmers and the merchants purchasing their crop began looking for a sort of “insurance” to protect themselves from price movements during the time between when a crop was planted and when it was sold/bought/delivered. The resulting futures contract was a commitment from the merchant to buy the crop from the farmer when it was brought to market, at a price agreed upon when the seeds were being planted. For farmers, the contract created an assurance of price — protection against a potential wheat price decline during the time between the planting and the sale; and the contract also created an assurance of price for merchants — protection against a potential wheat price increase during the time between the planting and their purchase. This “insurance” against the fluctuation of price allowed both the farmer and merchant to “hedge” or protect themselves.
As the futures market grew and became more respected and commonplace the actual contracts themselves began to change hands: If the merchant decided against buying the wheat, the futures contract would have to be placed for sale to someone else who did want the wheat-purchase obligation; and if the farmer decided against selling the wheat, the futures contract would have to be placed for sale to another farmer who did want the wheat-sale obligation.
The futures market eventually expanded to include conditional futures — derived from underlying assets, and thus referred to as derivatives — and contracts were then written on all sorts of different assets; whereas before the futures contract required wheat to be exchanged on a specified date and price, now commodities and currencies and bonds and stocks all had futures contracts to exchange the requisite asset on a specified date at a specified price.
As the price of the futures contract moved up and down due to market conditions, the change allowed a potential for profits, and thus attracted other investors that were neither merchants nor farmers… An example: if poor weather conditions caused a smaller wheat crop, the contracts to sell wheat would likely be more valuable because of a smaller supply of wheat; but if good weather conditions caused a larger wheat crop, the contracts to sell wheat would likely be less valuable due to a larger supply of wheat. In this respect, for some individuals futures may be used to “hedge” or protect against price fluctuations, while for other individuals futures may be used to speculate in price movements — the method of use depends on what other assets and investments that individual owns. If one owns a large quantity of coffee, buying a “hedging” coffee future may protect against price volatility, but if one does not own any coffee the future may result in speculation — a similar method applies to other assets that a futures contract can be written on (i.e. stocks, bonds, currencies, etc.).
Moving forward to modern day managed futures — an investment category that was once almost exclusively seen in the hedge-fund format — one now has many choices available including the liquid alternative investment format (example: a mutual fund that invests in futures contracts). Potentially one of the most misunderstood investment types, the confusion surrounding managed futures is likely due the tendency to lump together an extremely broad category of investments under one name, when the underlying diversity — both of market focus and investment-style — should likely cause the group to be subdivided. More specifically, within the managed futures investment category there are many different investment styles (trend following, counter-trend following, and market neutral futures strategies) as well as many different underlying assets that the futures contracts are written on (commodities, currencies, bonds, stocks, etc.) and they each have different volatility and return characteristics — their performance can be very different from each other.
Market Focus of Managed Futures
Some managed futures funds focus solely on futures contracts written on commodities, some exclusively on S&P 500 futures, and some are diversified managed futures funds that may look to diversify among many different futures contracts (commodities, currencies, stocks, bonds, etc.).
Investment Style of Managed Futures
Before detailing the investment styles a brief description of price-noise and price-volatility is necessary…
Price-noise refers to the amount of price reversals occurring; if price-noise is high, there are many changes in the direction of price (many inflection points) — price moves up, then down, then up, then down.
Price-Volatility refers to how extreme the change in price is (the amplitude of the chart); if price-volatility is high the price moves way up, then way down, then way up, then way down
The chart above shows two prices (blue and green lines) — they both have price-volatility and price-noise as they both change directions and move up and down, but the green line has more price-noise than the blue line and the blue line has more price-volatility than the green line — i.e. the green line changes direction more (higher price-noise) and the blue line’s changes are more drastic (higher price-volatility).
- Trend Following Strategies:
- This strategy attempts to invest in the same direction as an existing short-, medium-, or long-term price trend and relies on the price continuing in the same direction that it’s been moving in, whether up or down
- Typically performs well in periods where price-noise is minimal
- Performance can be hindered by “noisy” price movements and frequent, unexpected reversals in price
- Counter-Trend Following Strategies:
- Attempt to invest against recent trends in price, profiting from “price-oscillations” (i.e. back-and-forth swings in price): Buy on downswings in price, when oversold levels are reached; sell on upswings in price, when overbought levels are reached
- Typically performs well in periods where price-noise is high
- There is a potential for positive returns in a “directionless” market (price moves up, then back down to the starting price, then down below the starting price, then back up to the starting price, etc.)
- There is a potential for amplified returns when both price-noise and price-volatility are high; however, this environment can simultaneously create longer waiting periods for returns to materialize (i.e. longer drawdown periods where performance suffers temporarily)
- Performance can be hindered when a smooth trend emerges (price moves up and continues to move up, or price moves down and continues to move down)
- Market Neutral Futures Strategies:
- Non-directional trading strategies such as options-premium selling and spread trading are strategies that depend more on the difference between futures contracts than on an overall price increase or decrease; they may attempt to invest around situational events such as contango and backwardation — topics that are likely beyond the interests of the casual reader but are mentioned briefly below
Brief Explanation of “Futures Curves”
Two common charts are often seen when addressing futures: One shows the current purchase price of many different contracts, and another shows the how the price of a specific futures contract changes over time.
Prices of Various Futures Contracts
A normal futures curve is occurring if it is more expensive to buy a futures contract that has an end date further in the future; an inverted futures curve is occurring if it is cheaper to buy a futures contract that has an end date further in the future. This curve changes based on the perception of costs and conveniences associated with holding the underlying asset that the contract was written on.
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Price Change of One Specific Futures Contract
Contango is the description of a futures contract price that is above its “spot price” (the contract’s ending price, established and agreed upon when the contract was written); backwardation is the description of a futures contract price that is below its “spot price”. The price chart can oscillate around the spot price going above or below (contango or backwardation) depending on influences in supply and demand (example: weather may affect a wheat crop and change the futures contract price, etc.) but the price eventually converges with the spot price as the end date of the contract (i.e. the delivery date of the asset) draws nearer.
The variation in market focus and investment-style is why the group is so broad and diverse — some managed futures are more narrow in their focus and some are more diversified; it’s also what creates the diversity in performance and volatility characteristics for the group. However the commonality of managed futures is that — due to the nature of their price movements (i.e. they move based on the supply and demand of the underlying asset, and based on management techniques) — they’re likely medium-to-high volatility investments that are uncorrelated with traditional asset classes — an attribute that may be beneficial in an environment of low long-term expected returns for equities and fixed income (see Six Charts Worth Remembering).