What are commodities, futures and managed futures accounts?

Most people are familiar with stocks. If a coworker religiously stops for their morning coffee on the way to work, one might even say something like “You should buy stock in Starbucks!”.

But what is Starbucks buying? Coffee futures.

Coffee is one of many physical commodities. Futures are the way most farmers and producers (like Starbucks) manage their risk to volatility in the price of coffee. Futures are also used by speculators who look to profit from short term fluctuations in the price of coffee. 

What is a commodity?

Commodities are traditionally physical products or raw materials that are grown, mined, or otherwise created for sale to producers who create other goods that are meant for direct consumption. Some examples would be coffee, cocoa beans, wheat, corn, lean hogs, live cattle, soybeans, frozen concentrated orange juice and many others. Metals like gold and copper as well as energies like natural gas and crude oil are also considered commodities.

What are futures?

Futures contracts represent one of the ways that commodities can be traded. Futures contracts are standardized to size and quality specific to each underlying commodity. The contract is a binding agreement that the contract holder will either deliver or accept delivery of the commodity upon contract expiration. Contract expiration dates can vary across commodities. 

Typically futures contracts are used by suppliers and producers to hedge their risk against price volatility. For example, let’s say the price of corn is relatively high in May and an Ohio farmer would like to take advantage. However, his corn is still in the ground and won’t be harvested until the fall. What can he do?

He can sell corn futures against his upcoming crop with a contract expiration in September. This way he locks in his sales price when corn values are high in May and he no longer has to worry about the price of corn collapsing just as he’s getting it out of the ground. This is an example of hedging.

But what if you are not a farmer or do not have room to store 5000 bushels of corn? Are you forbidden from trading futures contracts? Of course not. If you are the holder of a futures contract you can avoid delivery as long as an offsetting position is taken prior to the contract expiration date. This is what speculators do.

Although often vilified, speculators play a vital role in the futures markets. Speculators provide liquidity to the market and provide relative price stability. For an example, let's go back to our Ohio farmer. Say he wants to sell futures against his crop in May but the producers (cereal makers, ethanol producers, etc) are not willing to pay the market price. Maybe they don’t need the corn until next quarter, so they can afford to hold out for a better deal. 

Enter the speculator. The speculator comes in and buys that corn futures contract from the farmer at the market price, transferring risk from the farmer to the speculator. What does the speculator get for taking risk? If the price of corn continues to go higher, the speculator takes the profit without ever having to start a tractor. When the speculator thinks the price of corn will no longer rise, he will sell corn futures to offset his position and return to flat.

What is a managed futures account?

Some futures speculators not only trade futures contracts for themselves, but can also make trades on the behalf of others. These speculators are called Commodity Trading Advisors (CTAs) and the client accounts they manage are called managed futures accounts.  

Managed futures accounts are different from commodity pools or hedge funds because the accounts are still owned by the client. No money is actually transferred from the client to the CTA. The client simply authorizes the CTA to make trades in their account. The CTA typically charges a performance fee, which equates to some percentage of the profits.

A CTA must pass the Series 3 exam and become a member of the National Futures Association (NFA). The NFA levies strict regulatory requirements pertaining to performance reporting, marketing, and risk disclosures. 

Despite their name, CTAs are not limited to only trading commodity futures. There are also futures contracts for financial instruments like stock indices, foreign exchange and treasuries. All of these futures can also be traded in a managed futures account.

All of this is great information, but what does it really mean for investors? Are commodities a good investment? For long term investors, investing in individual commodities is not very common. For short term traders, commodity futures can be an attractive alternative to equities.

For long term investors seeking exposure to the benefits of commodity trading, a managed futures account would be a better option.