Why Futures Prices Converge Upon Spot Prices 

Introduction

• Futures are financial contracts that establish predetermined values for buying or selling securities on a specified date. Unlike options, both buyers and sellers are obligated to fulfill the contract terms.
• In trading futures, two prices are involved: spot and futures. As the futures contracts mature, these prices tend to converge.
• In this blog, we will explore the factors behind this convergence.

What are Futures and Spot Prices?

• Futures trading allows investors to commit to buying or selling a predetermined quantity of commodities at a set price for future delivery.
• Originating from the need to establish pre-agreed prices between producers and wholesale buyers, future contracts benefit both parties. 
• Producers secure a ready market and financing, while buyers can plan their budgets based on known costs.
• However, the initially agreed-upon price can fluctuate due to factors, such as natural disasters or changes in consumer demand.
• Traders aim to profit from the difference between the set futures price and the commodity’s actual value upon delivery.  

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Why Do Futures Prices Converge Upon Spot Prices?

• The basis, or spread, represents the disparity between spot prices and futures prices in a futures contract.
• Initially, when two traders enter into a futures agreement, spot and future prices differ. However, these prices tend to converge with time.
• The basis diminishes as the future approaches maturity, eventually reaching zero. This convergence occurs when future prices align with spot prices. The two key factors that drive this convergence are as follows:

 Arbitrage

Arbitrage involves traders exploiting price variations by buying and selling assets across different markets. Short futures contracts enable traders to buy the underlying assets for delivery. The increased supply resulting from arbitrageurs shorting contracts causes a decline in prices, thereby aligning spot prices with future prices.

 Demand and supply

Since arbitrage allows for risk-free trading, it impacts the supply and demand dynamics of underlying assets. Increased share purchases drive up demand, which leads to futures prices convergence with spot prices. 

What Does This Convergence Mean to Everyone?

• The convergence of futures prices and spot prices assures futures and options traders.
• This minimizes the risk of significant losses upon delivery. It also presents lucrative opportunities for investors who profit from trading contracts.
• For commodities, particularly agricultural commodities where contracted pricing originated, this convergence enables farmers to continue their work with confidence, knowing a buyer is secured and their earnings are predetermined.
• Similarly, buyers can accurately anticipate their expenditures, facilitating effective cash flow planning.

What are the Tips to Consider During These Convergences?

When trading futures, it is essential to consider the following factors:

• For arbitrage strategies, be aware that prices may not behave as predicted. It will potentially lead to a decline in the futures contract’s values as compared to spot prices, although convergence occurs at expiration. New investors with low-risk tolerance should be cautious about these risks. 
• Unlike options, futures obligate you to buy or sell securities regardless of market conditions, which can lead to significant losses. 
• To capitalize on supply and demand dynamics, consider purchasing securities when spot prices are high and selling them simultaneously. However, this strategy is widely used, causing spot prices to decline rapidly, and limiting the profit window for traders.
• Exercise caution and implement sound risk management when navigating these intricacies of futures trading. 

Conclusion

• To sum up, arbitrage trading and the forces of demand and supply exert a back-and-forth influence on the stock price as the delivery date draws near.
• This dynamic interaction gradually brings the stock price closer to the futures price.
• This convergence phenomenon generates potential opportunities for arbitrage trading, enabling traders to profit from buying and selling futures contracts.
• It is essential to note that both these strategies carry inherent risks, as is the case with any investment strategy on the stock market.
• Caution and careful risk assessment are essential when engaging in such trading activities. 

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