Futures exist for one reason and one reason only, to manage price risk! Some form of Futures trading has been around for hundreds of years for people who have owned a physical commodity or needed to own a physical commodity.
These people or entities would be called commercial traders. They use the physical commodity in their day to day business. Perhaps they have grown it, extracted it from the earth or produced it. These commercials would be known as producers. If they needed to purchase a physical commodity to process, refine or manufacture, then they would be called a processor.
Either way, these two commercial types have something in common. Price Risk! We would all like to own something and have the price go straight up and then sell it. Or we might need to purchase something and we would like prices to keep falling until we needed to actually buy it. Ah, the perfect world it would be. But in the real world these commercials know these conditions do not exist on a reliable basis.
Let’s look at a Cash Corn chart provided by Moore Research that illustrates what months of the year tended to be the high and low prices for the last 30 years. MRCI makes these charts available for traders to help time cyclical tops and bottoms. As traders, we would then take this information and find technical chart levels to buy or sell at. Having these seasonal highs and lows is known as having an edge in trading. Figure 1 shows the average price for the last 30 years in purple.
If you owned corn and had just planted your annual crop in the spring time, you can easily see what the price is most likely to do by the time you harvest your crop. Fig. 1 shows that corn typically makes its seasonal highs in the early to mid-spring and continues to decline right into the fall harvest season. There are some fundamental factors behind this seasonal pattern. In the spring corn has been depleted from the grain elevators reducing supply and causing price to rise. In the fall corn will be harvested by all producers and brought to market creating an abundance of supply, thus lowering prices for the physical crop and Futures contract on corn.
As a producer of corn you would be at risk of losing profit by the time you harvest your crop unless you protect yourself with an insurance policy against lower prices. This insurance is known as selling a corn futures contract that will expire in December of that harvest year. The Futures industry knows this as Hedging. Now, at harvest time you will lose on your cash crop when taken to the grain elevator, but the Futures contract you shorted will be protecting your profit as it makes money with falling prices of corn. As long as the basis (difference between cash and Futures) stays relatively the same the Hedge should protect the commercial producer.
The commercial processor in corn could be a rancher in need of feed for his livestock, ethanol refiners, a food processor or for export. The processor is at risk of having prices rise before he can purchase the cash crop. Looking at Fig. 1, we see that corn usually has its seasonal lows from September to November. This is simply because of the massive supply of Corn being brought to the market at the same time. It is at this time the processor can be buying Futures contracts at today’s low prices due to the harvest season, but using contracts for delivery at some future date when the processor actually needs the physical corn. By using the Futures market the processor won’t have to pay for storage cost until he needs the corn to process.
Both the producer and the processor may use Futures contracts, Options on Futures or both for their Hedging.
For these reasons we have Futures markets. Commercials are the reason they were created and today they still exist because the Commercials must have them to manage price risk.
“I’ve learned that people will forget what you said, people will forget what you did, but people will never forget how you made them feel.” Maya Angelou