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Commodity Spreads 9: Spot Price

7 Feb 2018,

In the last part of our spread series, I have made a teaser for spread building. However, I have realized, that we haven´t understood yet one very important thing – the convergence of futures contracts to the spot price. This is a key element to understand the direction of the spread movement.

 

What we already know:

 

Great, we’re doing well. Today, we add another explanation – convergence of the term structure curve to the spot price. If you have not heard the word “spot price”, don´t be afraid, I will explain everything.

 

Spot price

Let´s return to futures contracts. Their price reflects an expected price in the future. On the contrary, the spot price marks the commodity price with instant delivery. It works in the same as when you realize that you need tomatoes for you lunch immediately. You go to the store and buy it. Transferred to the terminology of commodity markets – you buy tomatoes at a spot price.

But it’s not that easy because there are many spot prices. Just as tomatoes are sold in many stores in your area (and for various prices), also there are many physical markets for the particular commodity. Spot prices can, therefore, vary locally. For example, one cannot say that the current spot price of corn is $ 4 per bushel.

In fact, the spread trader does not even need to know the spot price exactly. What is more important is to know where the spot price is roughly situated:

  • If the market is in contango, the spot price is usually under the term structure curve. If the market is backwardation, the spot price is usually above the term structure curve.

In its essence, it is logical. If we want to buy corn immediately, the seller has no longer to store the commodity. Therefore, the seller does not need not include storage costs. Thus, if the market is in the normal state, that means there are sufficient amounts of corn and the term structure is in contango, there is no reason why the spot price should be higher than the price of the futures contracts. Therefore, it is usually under the term structure curve.

 

The red line shows the expected location of the spot price

 

But if the market is in backwardation, the situation is different. As I have already described, backwardation will occur if the demand for commodity suddenly grows or there is a problem on the supply side. In such situation, buyers want to secure that they will obtain the commodity and are willing to pay for it. That is why the prices of the nearest futures contracts are more expensive and logically the commodity with the closest delivery has the highest price. For this reason, the spot price, in this case, is mainly situated above the term structure.

 

The red line shows the expected location of the spot price

 

Spot price as a magnet

And now the relationship with spreads. The spot price affects the term structure curve as a magnet. And as you know, the magnet attracts the closest objects. The spot price attracts the entire term structure curve, but most affected are the nearest contracts. More specifically, the term structure curve tends to converge to the spot price. BUT … Nearest contracts tend to converge faster than those more distant.

Remember the rubber band from the last part of the series. When the rubber band stretches, the distance of two points on the rubber band increases and vice versa. So, happens, when part of the term structure moves faster, the term structure is expanding or shrinking. This effect also causes the movement of our interdelivery spreads.

 

What’s next?

Maybe you already know what connection is between the convergence to the spot price and two different spread strategies, namely bull and bear spreads. Try to think about it and you may write it here to the comments and we will discuss it next time.

 

 

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