Looking into the world of finance and trading, you will notice that there are many different financial instruments both for long term investment as well as short term investment. This article will focus on Futures contracts and what the main difference is between financial futures and commodities.
A futures contract is an agreement between the buyer and the seller of a specific product to be paid for today and delivered later in the future. Let’s assume that I own a company which distributes corn-based products. I anticipate that the price of corn is going to go up in the next 6 months. What do I do now? I can buy a futures contract where I will pay todays value, for delivery of the corn later in the future. Essentially futures contracts are a financial asset for Speculating the future price and for Hedging against the future price.
In the world of futures trading, there are 6 main product groups. These are:
- Interest Rates
- Foreign Exchange (FX)
Although we have 6 main products, there are only 2 main differences between the product groups. One half of the group are Financial Futures and the other half are Commodity Futures.
Financial Futures include:
- Interest Rates
- Foreign Exchange (FX)
Commodity Futures include:
To understand the difference between the two groups, lets first define Commodity Futures. A commodity is a physical product that has been naturally created on Earth. These include Oil/Petroleum, Natural Gas, Corn, Wheat, Gold, Silver, etc.
Financial Futures are Derivatives of specific products created by Humans through Financial Engineering. These include Stocks, Options, Bonds, Currency, etc. It’s safe to say, that if Dollars grew on trees, then currencies would be commodities (HaHa!)
These two differences also affect how each specific market behaves and how traders trade. For example: If the USDA’s Crop Report says that there has been an increase in Corn supply, would this affect the S&P 500 Futures? – Probably not because the S&P’s fundamentals do not include the price fluctuation of Corn. Conversely, if the Non-Farm Payrolls report (Jobs Report) says that the US jobs growth increased this month by 200k jobs, would this affect Cotton Futures? – Again, probably not, because the price of Cotton does not depend on the increase/decrease of jobs in the US Economy.
So, what moves the Index Futures and what moves the Energies Futures? The main driver of price fluctuation in each individual market is known as the Fundamentals. Fundamentals explain the specific events that make prices move up or down for each market.
Here is where it gets interesting. What are the fundamentals of Financial Futures and the fundamentals of Commodity Futures. Here is the simple answer:
Let’s focus on the S&P 500 Futures. We know that this is an Index Future that tracks the performance of the S&P 500 index. In other words, its just fancy financial engineering which allows the creation of a large leveraged product to mimic the movements of an Index that does not trade like an asset. Think about it, if you tried to buy the S&P 500 index right now, the only way to do it would be to either buy the Futures or buy the ETF (Exchange Traded Fund) that tracks the performance of the S&P 500 index. It is impossible to buy the index itself because it is not an asset available for trade.
The S&P 500 Futures are a Derivative of the S&P 500 index. The next question is, what makes the S&P 500 index move up or down? The answer is the Stock Market. The S&P 500 is a basket, per say, of stocks. In fact, it is the top 500 Large Cap companies. Each individual company/stock with its own set of fundamentals, but we won’t dive that deep in this blog post. The overall performance of each individual stock will move the price of the S&P 500 index and the movement of the index is mimicked by the S&P 500 Futures.
Therefore, the main fundamental for an Index future is the stocks that make up the actual Index. If we wanted to know the reason for an up move or a down move in price, we can simply just look at the performance of the stocks that make up the index. This explains situations where we see an index market like the Nasdaq 100 down -1.00% while the Dow Jones Industrial Average is up 0.50%. The reason is the fundamentals.
Nasdaq 100 is completely made up of the top 100 technology stocks. The Dow is composed more of industrial stocks, construction, some technology, and Banking stocks. The Dow is more diversified because it has multiple sectors, where Nasdaq 100 has only 1 or 2. If it is a day where the market is selling technology stocks and buying Bank stocks, then we should see the Nasdaq 100 down and the Dow up, flat, or slightly lower but never worse than the Nasdaq.
Let’s focus on the Crude Oil Futures and Soybean Futures. As explained, commodities are physical products that are always on demand. We will always use fossil fuels and need to eat. Commodities will not go out of business. Stocks can file for bankruptcy. Even a stock that depend on the use of crude oil, could go bankrupt for reasons that don’t involve the actual commodity.
When trading commodities we don’t have to worry about CEO changes in company or company earnings or some unforeseen black swan event that will drive the price to zero. The main fundamental that drives commodities higher or lower is Supply and Demand.
Here are the scenarios:
- Supply > Demand = Low Prices = Demand < Supply
- Supply < Demand = Higher Prices = Demand > Supply
When Demand is high in a commodity, the Supply runs slightly lower and this will increase the price of the commodity. When Demand is low, there is more Supply in the market and will decrease the price of the commodity.
Think about every Wednesday in Crude Oil, The Crude Inventory report by the Department of Energy. This report measures the total supply in the market. Typically, if we have less supply (Inventory Draw), the crude oil futures trade higher in price and if we have more supply (Inventory Build), then the futures trade lower.
Another way of viewing the fundamentals of a specific commodity is by using something called a Seasonality chart. Let’s use Soybeans as an example. Soybeans are planted and harvested for many applications. In fact, there are two other Soybean futures markets: Soybean Meal and Soybean Oil. Soybeans are an Agricultural product.
We know that commodities mainly trade based on supply and demand. There is another neat little trick into looking at when the supply is greater, or the demand is greater. Look at these two Seasonality charts of Soybeans:
In blue we can see the price of Soybeans YTD, while in the red we can see the price of Soybeans on Average over the past 5 years. This is a 5-year seasonality chart. Notice the color of the background as well. Blue is Winter, Green is Spring, Yellow is Summer, Maroon is Fall. In this example, it is fair to say that Soybeans usually have a rally in the Winter and Spring months and Sell off in the Summer before consolidating in the Fall.
This makes sense. Upon further investigation and research into the Soybean crop, we find that planting of the crop begins in the summer time. Harvest begins in November. Pretty much a Selloff during planting and rally during harvest. Coincidence? Nope. This happens because farmers plant a lot of seeds and the estimates of what will be harvested looks really high (A LOT OF SUPPLY). When it comes time to harvest the crop, its not always as good as it looked during planting season, or something happened prior to harvest season that destroyed a lot of the supply. Knowing this information, we can see how prices behave during specific seasons and when to pull the trigger on a potential trade.
But like trading, nothing is ever this easy. The planting and harvest season schedule I talked about is only for the US Soybean Crop Production which is about 38% of the worlds production.
Here is what the Schedule looks like: Planting / Harvest
- 38% – United States: Late April through June / Late September through the end of November
- 25% – Brazil: Mid-August through mid-December / February through May
- 19% – Argentina: October through December / April through early June
- 7% – China: Late April through mid-June / September through early October
Here is one last example of how the global Soybean production affects overall prices:
This chart shows a 5-year seasonality chart. The difference here is that we can see all 5 years on the chart plus the YTD, in blue. Have a look at the gray line that the arrow is pointing at. This was the year 2016. It’s the year that there was a disaster in the harvest season in Argentina while at the same time, planting season in the US. Heavy rains and flooding destroyed a very large portion of the harvest in Argentina. Supply was decreased dramatically, and the price of Soybeans sky rocketed to highs that we haven’t seen in a total of 5 years.
Lastly, lets analyze Gasoline futures on a seasonality chart and explain the behavior:
Here we can see that over the past 5 years Gasoline prices rise from winter into the summer months and begin to roll over in mid-summer into the winter. This makes sense. When we take a look at the major use of gasoline, we know that it’s used for energy to drive vehicles, airplanes, boats, and mostly used in the spring and summer during the traveling season. When the traveling season winds down, the price of gasoline falls. Air fare gets a bit cheaper. And when the Fall begins alongside back-to-school, prices just decline hard, until the next traveling season begins.
It is important to note that Seasonality charts explain commodities’ behavior better than a stock or financial futures behavior. Stocks generally go up forever. If that’s the case, then the seasonality chart doesn’t make sense to use. You will only be seeing the overall averaged percentage return YOY (Year-Over-Year) because stocks are not seasonable. Bond prices, currency pair prices are not seasonal.
After reviewing the evidence and looking into a few futures markets, we can see that Financial Futures and Commodity Futures are different. Their Fundamentals are different, their trading behavior is different and the techniques for analyzing them can help make trading decisions.