This chapter is from the book
This chapter is from the book
This chapter is from the book
Cash Market Versus Futures Market
Currently, commodities are traded in two separate yet related markets: the cash market and the futures market. The cash market refers to the buying and selling of physical commodities. In a cash market transaction, the price and exchange of product occurs in the present. In contrast, the futures market deals with the buying or selling of future obligations to make or take delivery instead of the actual commodity.
Cost to Carry
Prices in the cash and futures market differ as a direct result of the disparity in the timing of delivery of the underlying product. After all, if a commodity is going to be delivered at some point in the future, it must be stored and insured in the meantime. The costs associated with holding the physical grain until the stated delivery date are referred to as the costs to carry.
Naturally, in normal market conditions, the cash price is cheaper than the futures price because of the expenses related to carrying the commodity until delivery. Likewise, the near-month futures price is generally cheaper than a distantly expiring futures contract. The progressive pricing is often referred to as a normal carrying charge market (see Figure 1.1). You might also hear this scenario described by the term contango.
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Figure 1.1. Normal carry charge market, or contango.
Normal carrying charge markets are possible only during times of ample supply, or inventory. If there is a shortage of the commodity in the near term, prices in the cash market increase to reflect market supply-and-demand fundamentals. The supply shortage can reduce the contango or, if severe enough, can actually reverse the contango if the spot price, and possibly the price of the nearby futures contract, exceeds the futures price in distant contracts, as shown in Figure 1.2.
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Figure 1.2. The opposite of contango is sometimes called backwardation and involves higher spot prices than futures prices.
It is important to understand that the contango shouldn’t exceed the actual cost to carry the commodity. If it did, producers and consumers would have the opportunity for a “risk-free” profit through arbitrage.
- “If you can take advantage of a situation in some way, it’s your duty as an American to do it.”
- —C. Montgomery Burns (from The Simpsons)
Arbitrage
Arbitrage is the glue that holds the commodity markets together. Without arbitrage, there would be no incentive for prices in the futures market to correlate with prices in the cash market—and as I discuss in Chapter 2, “Hedging Versus Speculating,” arbitrage enables efficient market pricing for hedgers and speculators. Specifically, if speculators notice that the price difference between the cash and futures prices of a commodity exceeds the cost to carry, they will buy the undervalued (cash market commodity) and sell the overvalued (futures contract written on underlying commodity). This is done until the spread between the prices in the two markets equals the cost to carry.
The true definition of arbitrage is a risk-free profit. Sounds great, doesn’t it? Unfortunately, true arbitrage opportunities are uncommon, and those that do occur are opportunities for only the insanely quick. Chances are, you and I do not possess the speed, skill, and resources necessary to properly identify and react to most arbitrage opportunities in the marketplace.
For further clarification, an example of an arbitrage opportunity unrelated to cash market pricing is a scenario in which the e-mini S&P is trading at 1380.50 and the full-size version of the contract is trading at 1380.70. In theory, if you noticed this discrepancy in a timely fashion, it would be possible to buy five mini contracts and sell one big S&P. The mini contract is exactly one-fifth the size of the original and is fungible; this means that trading five mini contracts is identical to trading one big contract. Consequently, a trader who can execute each side of the trade at the noted prices can request that the positions offset each other to lock in a profit of 20 cents, or $50 before transactions costs. It doesn’t sound like much, but if it truly is an arbitrage opportunity, a $50 risk-free profit isn’t such a bad deal.