If you have been observing how spot prices and futures prices tend to rush towards one another – like lovers running towards each other in an old Bollywood film – as the delivery date approaches, you’re probably wondering if you have witnessed a series of coincidences, or if a legit phenomenon is in play (or if someone somewhere is manipulating things).
Well, if you were leaning towards option 2 – a legit phenomenon, you were right. Current stock prices (spot prices) and futures prices do actually gravitate towards one another because of market forces in play, and legitimate ones only.
Market forces in play
The two most relevant market forces that enable the phenomenon of future prices converging with spot prices are:
- Arbitrage moves
- Demand and supply economics
How the phenomenon plays out
When a trader – let’s call her Tania – buys a futures contract, she agrees to pay – let’s assume Rs 100 – per share for 500 shares by March 2022. Tania pays Rs 200 for the contract. Tania is expecting the stock price to increase to Rs 150. The current stock price is Rs 80. Tania is a futures & options trader and looks to make her earnings from the purchase and sale of contracts because the contract prices fluctuate as their appeal fluctuates depending on how the price mentioned in the contract compares with the price that the stock is trading at on the market.
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Enter, Arbitrage
Towards the end of February, the stock price is around Rs 110 and some traders see an opportunity for arbitrage – a strategy of capitalizing on pricing differences of the same asset in different markets.
Another trader, Karthik decides to swoop in on the arbitrage and he buys Tania’s contract for Rs 1000. Karthik is paying a decently high price for the contract but he does not mind because his strategy is to buy the contract and take the delivery of the shares at Rs 100 and will sell them at Rs 110 – he is expecting earnings of Rs 5000 and therefore might not mind paying such a high price for the future contact.
Tania walks away from the trade pleased with her earnings of Rs 800. She’s out of our lens now.
Let’s take our focus on the stock price. Just like Karthik, many arbitrage traders start to buy the stock as the delivery date draws near and the stock price is still higher than the price mentioned in the contract. All of them have the same strategy as Karthik.
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Enter, demand & supply economics
Now the other market force in play – demand and supply economics – kicks in. Karthik and other arbitrage traders, by virtue of selling shares after taking delivery, change the market dynamic. By selling shares – or in other words, by increasing supply – the stock price drops.
It could even drop to Rs 100, in which case the spot price and the futures price would have converged.
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The reverse situation
Let’s say it was the opposite and stock prices stayed at Rs 80, as they were when Tania bought the contract. Why would anyone agree to buy shares at Rs 100 when the current price is Rs 80?
Well, actually Tania did buy at exactly that price and there will be other contacts buyers who will do so as well because of two reasons:
- Some traders look to benefit from the difference in futures contract prices, like Tania. They look to buy contracts at a lower price and sell them at a higher price.
- A trader might be predicting that the stock price will rise quickly once it crosses Rs 100 and therefore might agree to buy the stock price when it reaches Rs 100.
The phenomenon would play out similarly if Tania had a contract to buy and the same forces came into play.
What this phenomenon means for everyone in the mix:
- This phenomenon means that (although there is no guarantee) futures and options traders will not take very tremendous losses on delivery eventually because the spot prices and the futures prices end up being equal or almost equal.
- It creates opportunities for investors who make their earnings on trading contracts – like Tania.
- For commodities, especially for agricultural commodities, where the concept of contracted pricing actually emerged, it means that farmers can carry on their work knowing that a buyer is waiting in the wings, and knowing how much they will earn. Meanwhile, on the buyer’s side, they know exactly how much they will spend and can plan cash flow accordingly.
Top considerations for investors looking to capitalize on this phenomenon
- If you’re playing Tania’s hand and are gunning for earning off of differences in futures contract prices, keep in mind that prices may or may not move as predicted and you might end up holding a contract that is even lower in value than when you first bought it.
- If you’re looking to play Karthik’s hand, you must keep in mind that you might buy shares when the spot price is higher intending to sell, but as other people pursue the same strategy as you, the spot price could fall before you have time to sell.
- In duties trading (unlike options) if you are left holding the contract and someone meets your price by the delivery date, you are obligated to buy/sell. Your losses could be tremendous if things do not play out in our favour.
Conclusion
Arbitrage trading and demand and supply economics pull and push at the stock price as the delivery date approaches. The result of this tug-of-war is the stock price closing in on the futures price.
This phenomenon creates opportunities for Arbitrage trading and for traders to benefit from buying and selling futures contracts. Like all stock market investment strategies, both of these strategies too, present considerable risk.
