What is a Futures contract? How do Futures prices work?

Summary

  • The underlying price and its futures price move in sync, but in absolute terms the prices actually differ and are not the same.
  • This difference between the futures and the spot price (the underlying price) is called the basis or spread.
  • During dividend declaration the futures price often trades at a discount.

Many investors/traders might have heard about the futures market or derivatives market which is slightly more complex in its operations than the spot or cash market. However, once an investor understands the intricacies of the derivatives market, he/she can get an idea as to where the price may head in the near future.

 A futures contract is just the derivative of its underlying security or index and therefore, is designed to move in sync with its underlying. That means, if the underlying security’s price moves up, its futures contract is also expected to move up by the same amount and vice versa.

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However, a few times this relationship may get distorted, which could offer some clues as to what the futures traders/speculators in the derivative market are up to. To understand these clues, we first need to understand how the futures price is determined.

The underlying price and its futures price move in sync, but in absolute terms, the prices actually differ and are not the same. Most of the time, the underlying price is lesser then its futures price. For e.g., If the underlying is quoting at $10, its futures could be trading at $10.5. This difference between the futures and the spot price (the underlying price) is called the basis or spread.

This spread is attributable to the Spot-Future Parity which is the difference between the spot price and the futures price on account of variables such as expiration date, interest rates, dividends etc.

As time to expiry is one of the factors that determines the futures price, it is to be noted that the longer the time to expiry, the higher the premium would be and vice versa. This is one of the main reasons why the next month’s futures contract generally trades at a higher premium than the current month’s futures contract.

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Using the above-mentioned variables, the futures price is decided – which is the fair value or the theoretical value of the futures contract. However, the actual price could vary a lot depending upon the forces of demand and supply and other market variables such as transaction cost, margins, etc.

This fair value when trading above the spot price, which is the right order of things mathematically, is called premium, which is also commonly known as the Contango in the commodities market.

Sometimes, the futures price could fall below the spot price owing to short-term demand and supply imbalance. When this happens, the futures price is said to be trading at a discount, commonly known as Backwardation.

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How to gauge the future direction

Almost all the time, the futures price trades at a premium which is around the fair value. However, as discussed above, due to excessive buying the premium could rise to a much higher level, surpassing the theoretical price.

This jump through excessive buying, indicated by a sharp rise in the premium could indicate an uptrend in the near future. The premise being, there must be a good forecast of upcoming uptrend for the speculators, for them to be willing to pay more than the fair value.

Image Source:  © Embe2006 | Megapixl.com

However, one thing is to be noted, the farther one goes in the contract expiry, the higher would be the premium. This has to be the case due to the Cost of Carry Model and should not be confused with excessive premium.

When the futures slip into backwardation, the premium turns to discount, which simply indicates that sellers are aggressively selling the futures contract, therefore, distorting the fair value. As in the case with the premium, selling below the fair value reduces the chances of profit. Therefore, there must be a good reason for sellers/short sellers to take this call, which is a forecast of downtrend.

During dividend declaration, the futures price often trades at a discount. This is due to the fact that when dividend is announced, that stock price gets adjusted and falls by the amount of dividend declared on the ex-dividend date. However, the futures price starts discounting beforehand and remains at discount till the stock goes ex-dividend.

In any case, this dividend-based discount should not be considered as a sign of an upcoming downtrend. It is just a mechanism to account for dividends.

Also, it is not very common to spot these market inefficiencies easily as when the futures price deviates a lot from its fair price, the arbitrage opportunity kicks in and the difference gets narrowed down in practically a few seconds or even less than that.

Arbitrage is a trade wherein one buys a cheap asset and short sells the expensive counterpart, which ultimately narrows down the difference and leads to what is called a “risk free profit”. These inefficiencies are less commonly spotted now due to high frequency trading, complex algorithms and high-speed trading infrastructure, which are specifically programmed to exploit these inefficiencies.

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