Cash Market Versus Futures Market
There are currently two separate, yet related, markets in which commodities are traded; 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 rather than the actual commodity.
Cost to Carry
Prices in the cash and futures market differ from one another 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 is referred to as the cost to carry. Specifically, the costs to carry include items such as storing and insuring the commodity prior to the date of delivery.
Naturally, in normal market conditions, the cash price will be cheaper than the futures price due to the expenses related to carrying the commodity until delivery. Likewise, the near-month futures price will be 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.
Figure 1.1 Normal carry charge market, or contango.
Normal carrying charge markets are only possible 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 it can actually reverse the contango should the spot price, and possibly the price of the nearby futures contract, exceed the futures price in distant contracts, as shown in Figure 1.2.
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 can'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.
Arbitrage is the glue that holds the futures 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 only opportunities for the insanely quick. The chances are that you and I do not possess the speed, skill, and resources necessary to properly identify and react to most arbitrage opportunities in the marketplace.
- "If you can take advantage of a situation in some way, it's your duty as an American to do it." C. Montgomery Burns (The Simpsons)
An example of an arbitrage opportunity unrelated to cash market pricing would be a scenario in which the e-mini S&P is trading at 1080.50 and the full-sized version of the contract is trading at 1080.70. 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 of the size of the original and is fungible.). Consequently, a trader that can execute each side of the trade at the noted prices can request for the positions to offset each other to lock in a profit of .20 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.