8 powerful points outlining the dynamics between spot Vs futures prices

8 powerful points outlining the dynamics between spot Vs futures prices.

What we’ll be covering:

1. Difference in timing
2. Impact of carry costs and convenience yield
3. Hedging vs. speculation
4. Price convergence (spot and futures)
5. Liquidity and trading strategy
6. Basis risk
7. Arbitrage opportunities
8. Influence of market news and events

 

A relatively innocent question from a junior dealer yesterday showed how necessary it is for all of us involved in the financial services, to understand how the markets work so we can serve our clients better.

The question related to whether the quotation on an asset provided to clients was derived from futures or spot liquidity and why the answer is important. It gave us a reason to outline 8 powerful points that outline their dynamic relationship, that reflects different aspects of the market. These aspects can influence trading decisions, risk management, and overall strategy.

 

Difference in timing

• Spot price: The spot price is the current market price for immediate delivery of the asset. It’s the price you would pay if you bought or sold the asset right now (on the spot). For example, if you’re trading the spot price of gold, it reflects the price you’d pay for physical delivery of gold today.
• Futures price: The futures price is the agreed-upon price for buying or selling the asset at a specified date in the future. Futures contracts allow traders to lock in a price today for a transaction that will take place later (often months down the line).

Why it matters: Traders need to understand this difference to manage timing risk. The spot price changes instantly based on current market conditions, while futures prices reflect expectations about where the market will go in the future. For traders holding positions over time, the futures price is more relevant, whereas spot price trading applies to immediate, short-term trades.

 

Impact of carry costs and convenience yield

Futures prices often incorporate inherent costs that can be expensive or cheap, causing the futures price to be higher or lower than the spot price, depending on whether the market is in contango (futures price is higher) or backwardation (futures price is lower).

• costs of carry (such as storage fees, financing costs, or dividends that will be paid in the future)
• convenience yield (for commodities, this is the benefit of holding the physical asset).

Why it matters: Traders need to understand these factors to assess whether the futures market is pricing in more expensive holding costs or is reflecting supply/demand imbalances that make future delivery more or less valuable than immediate delivery.

 

Hedging vs. speculation

• Hedging: Traders use futures prices to hedge against price fluctuations in the underlying asset. For example, a farmer might sell futures contracts for wheat to lock in a selling price for their crop months before harvest. The spot price doesn’t help with hedging because it reflects the current price of wheat, while the futures price locks in the price for future delivery.
• Speculation: Traders looking to speculate on price movements often trade futures contracts in hopes that they can profit from price changes. If they’re only looking for short-term movements, they may focus on the spot price.

Why it matters: Hedgers attempt to mitigate uncertainty seeking insurance against future price fluctuations by transferring the price risk to speculators. Speculators place bets to capture price swing opportunities adding liquidity volumes. Current spot and future prices reflect the market sentiment in real time, so being aware of where they both stand speaks volumes.

 

Price convergence (spot and futures)

Spot and future prices are always different. Under normal conditions, futures price is higher than spot known as contango, and at times they reverse known as backwardation.

But as a futures contract approaches its expiration date, the futures price tends to converge with the spot price. This process is known as convergence.

At expiration, the futures price and spot price should be nearly identical for the same asset.

Why it matters: The dynamics between futures and spot prices are in constant push-pull mode. Different economic environments (or seasons for agricultural contracts), can shock both prices. During convergence, prices might or might not behave as predicted (disconnection) yet its still a big element when trading either side.

 

Liquidity and trading strategy

• Spot Markets: In some cases, the spot market may have more liquidity, especially for highly traded assets like currencies and major commodities. Traders in the spot market typically aim for immediate price movements and often make quicker, short-term trades.
• Futures Markets: Futures contracts may offer greater liquidity for certain assets, especially for hedgers or speculators seeking to manage longer-term exposure or leverage.

Why it matters: Understanding whether you’re trading in the spot or futures market helps you design a trading strategy that matches the available liquidity, your time horizon, and the level of leverage you’re willing to take on.

 

Basis risk

This is the risk that arises from the difference between the spot price and futures price (called the “basis”). Traders who hedge with futures contracts face the risk that the futures price and the spot price may not move in perfect correlation. For example, a trader might sell a futures contract to hedge against a falling price, but if the futures price and spot price diverge unexpectedly, the hedge could be ineffective.

Why it matters: Traders need to understand how the basis works because the discrepancy between the spot and futures prices can affect their ability to properly hedge or make the most out of a position.

 

Arbitrage opportunities

Traders looking to exploit arbitrage opportunities rely on the price discrepancy between the spot and futures markets. If there’s a mismatch between the spot and futures prices (e.g., futures are priced too high or too low relative to the spot), arbitrage traders can execute strategies to ride the difference by buying the underpriced asset and selling the overpriced one.

Why it matters: Spot and futures prices can sometimes diverge significantly in markets with inefficiencies. Traders who are looking for arbitrage opportunities need to recognize when the price difference is large enough to make the trade profitable. For all the rest, large enough price differences signal arbitrage trading influx to be expected.

 

Influence of market news and events

• Spot Prices: Spot prices are directly affected by real-time market news such as supply disruptions, weather events, geopolitical news, that causes immediate price changes.
• Futures Prices: Futures prices reflect expectations about how news and events will affect future prices, which can lead to price movements based on predictions or forecasts.

Why it matters: Traders need to understand how to react to market-moving news based on whether they’re trading spot or futures prices. Spot price trading requires quick reactions to real-time events, while futures price trading may require more analysis and interpretation of future market expectations.

 

Our 20 year visibility in the space taught us that education is important, but without awareness it is not enough. Terms and definitions should be accompanied by an understanding of why things work, but also why they don’t. And although there is no consistent 100% accuracy in predicting what will happen next, everyday carries new lessons to be carried forward. Understanding spot vs futures dynamics is yet another important milestone in our trading travels.

*this article is provided for educational purposes only. It is not to be construed as investment advice and all visitors are encouraged to keep learning while understanding that trading is exciting but also carries unlimited risk. Lets all be responsible investors to make the most out of the experience.