Table of Сontents
- Spot Price Definition
- Spot Price vs. Futures Price
- Spot Price & Futures Price Example
- Spot Change & Over Spot When Buying Gold
- Bottom Line
Understanding how spot prices and futures prices relate to one another might help consumers better grasp the commodities trading market.
Spot Price Definition
The “spot price” is the current cost of an asset with immediate payment and fast or quick delivery to the customer.
Most assets trade at their spot price, assuming the transaction occurs instantly. Spot pricing is based on supply and demand.
A raw material is a commodity.
- Soft commodities: products that are produced, like wheat or rice
- Hard commodities: mining products, such as gold, oil, and silver
- Energy commodities: include oil, gas, coal, and electricity
Spot Price vs. Futures Price
In contrast to the spot price, which refers to an asset’s present price, the future price refers to the asset’s price at a future date. A futures contract binds the owner of an item and a prospective buyer to sell the asset at a predetermined future date and for a predetermined price. When a futures contract expires, the buyer must assume ownership of the underlying asset. However, the buyer can sell the futures contract at any moment before the expiration date, absolving them of the obligation.
The difference between a futures contract and an options contract is that an American-style options contract allows the owner the right, but not the obligation, to purchase or sell the underlying asset at any time before the contract’s expiration date.
Futures Price Example
The price of a barrel of oil is currently $91, and we’ll assume that the cost of storing per barrel over a six-month period will be $9. Assuming a 0.25 percent interest rate, the futures price for 10 barrels of oil would be $1,001.25, which is calculated as follows: ($1,000) * 2.17828 (.0025 * 0.5).
Basis Definition
The “basis” refers to the discrepancy between a commodity’s spot price and its futures price for the earliest feasible delivery date. The base in the previous case is $1.25. The base might vary significantly depending on where you are and where the product is owing to varying storage costs and the expense of transporting the item for delivery.
When deciding when to purchase or sell a commodity, commodities traders examine the basis to see if it is expanding or contracting.
Spot Price & Futures Price Example
Weather, political unrest, or labor strikes might all affect an asset’s current price at some point in the future. A wheat farmer may establish a futures contract at the start of a growing season to sell their whole harvest at the conclusion of that season in order to protect themselves against weather risk. A baking firm may purchase the farmer’s futures contract on the other side of the deal as a hedge against an increase in the price per bushel of wheat. Depending on whether they believe the price of wheat will increase or decrease, speculators may purchase or sell the same futures contract.
Three outcomes are conceivable at the futures contract’s expiration date:
- The futures price is less than the current spot price
- The futures price is greater than the current spot price
- The futures price is the same price as the current spot price.
The market is considered to be in contango if the futures price of a commodity is higher than the spot price, indicating that the price of the commodity is anticipated to increase. The market is considered to be in backwardation when the futures price is lower than the spot price, indicating that the price of the commodity is anticipated to decline. The spot price and the futures price often converge as the expiry date draws near.
Prices for futures, anticipated, and spot converge (Suicup/Wendorf/Wikimedia Commons)
Futures contracts are highly leveraged, which means that an investor only has to put up a tiny portion of the contract’s value, known as a margin amount, in order to invest. The quantity of the futures contract the investor is purchasing, the investor’s creditworthiness, and the broker’s policies all influence how much the broker will advance the investor. If an investor’s wager is unsuccessful, they may be liable for much more than the margin amount.
Spot Change & Over Spot When Buying Gold
The question of which occurred first between the spot price and the price of gold futures is kind of a chicken-and-egg scenario. The price at which an ounce of gold might be bought and sold right away is known as the spot price.
Contracts that specify a price for the gold’s future delivery establish the futures price of gold. The front-month futures contract with the most volume sets the spot price for gold. Let’s take an example where the spot price of gold is $2,000 per ounce today. If you look at the chain of gold futures contracts, you could notice that one contract that expires in two months is trading at the same price as one that expires in two months from now.
Bottom Line
While this article provides a foundational understanding of how commodities futures contracts operate, trading futures has a high risk of substantial losses. Before making an educated investment selection, further investigation and knowledge are required.
