Commodity Spot Price vs. Futures Price: An Overview
It may seem odd that something can have two prices at once. But it's quite common in the world of commodities trading. Every commodity—a basic type of natural or agricultural goods in its natural form, like gold, oil, wheat, or beef—is priced in a couple of ways: its spot price and its futures price.
Both the spot price and the futures price are quotes for a purchase contract—the agreed-upon cost of the commodity by the two parties, the buyer and the seller. What makes them different is the timing of the transaction and the delivery date of the commodity. One applies to a deal that's going to be executed immediately; the other, to a deal that's going to happen down the road—usually, a few months hence.
Key Takeaways
- The main differences between commodity spot prices and futures prices are the delivery dates.
- The spot price of a commodity is the current cash cost of it for immediate purchase and delivery.
- The futures price locks in the cost of the commodity that will be delivered at some point other than the present—usually, some months hence.
- The difference between the spot price and futures price in the market is called the basis.
- Broadly speaking, futures prices and spot prices are different numbers because the market is always forward-looking.
Commodity Spot Price
A commodity's spot price is the current cost of that particular commodity, for current purchase, payment, and delivery. In commodity spot contracts, payment is required immediately, as is delivery. The deal is done "on the spot"—hence, the name "spot price."
In a more general sense, a commodity's spot price represents the price at which the commodity is being traded at the current time in the marketplace. Traders and investors track the spot price of a commodity as they would stock prices. When people quote a commodity's price, as in "gold is trading at $1,800 an ounce," it's the spot price they're usually referring to.
Commodity Futures Price
The futuresprice applies to a transaction involving the commodity that will occur at a later date—literally, in the future. A commodity futures buyer is locking in a price in advance, for an upcoming delivery.
A commodity's futures price is based on its current spot price, plus the cost of carry during the interim before delivery. Cost of carry refers to the price of storage of the commodity, which includes interest and insurance as well as other incidental expenses.
Commodity futures prices can be calculated as follows: Add storage costs to the spot price of the commodity. Multiply the resulting value by Euler's number (2.718281828…) raised to the risk-free interest rate multiplied by the time to maturity.
For example, assume the spot price of gold is $1,200 per ounce and it costs $5 per ounce to store the gold for six months. The six-month futures contract on gold, given a risk-free interest rate of 0.25%, is $1,206.51, or (($1,200+$5)*e^(0.0025*0.5)).
The prices of commodities futures are not always higher than spot prices. Futures prices take into account expectations of supply and demand and production levels, among other factors. The difference in a commodity's spot price and the futures price at any given time is attributable to the cost of carry and interest rates.
The futures market exists because producers want the safety that comes with locking in a reasonable price in advance, while futures buyers are hoping that the market value of their purchase rises during the interim before delivery.
Special Considerations: Spot Price, Futures Price, and Basis
Spot and futures prices differ because the financial markets are always looking forward, and adjusting expectations accordingly.
The basis is the difference between thelocal spot priceof a deliverable commodity and the price of thefutures contractfor the earliest available date. "Local" is relevant here because futures prices reflect global prices for any commodity and are therefore a benchmark for local prices. The basis can vary greatly from one region to another based primarily on the costs of transporting the commodity to its delivery point. The local cash market price minus the price of the nearby futures contract is equal to the basis.
As an example for basis in futures contracts:
- Assume the spot price for crude oil is $54 per barrel
- The futures price for crude oil deliverable in two months' time is $50
- The basis is $4, or $54 - $50.
Basis is a crucial concept for portfolio managers and traders because this relationship between cash and futures prices affects the value of the contracts used in hedging. Basis is used by commodities traders to determine the best time to buy or sell a commodity. Traders buy or sell based on whether the basis is strengthening or weakening.
The basis, it must be noted, is not necessarily accurate. There are typically gaps between spot and relative price until the expiry of the nearest contract. Product quality also can vary, making basis an imperfect indicator.
The futures market exists because producers want the safety that comes with locking in a reasonable price in advance, while futures buyers are hoping that the market value of their purchase rises during the interim before delivery.
When the futures price is higher than the spot price, it is known as contango. Normal backwardation is when the futures price trades lower than the spot price.
What Is the Difference Between Spot Price and Futures Price?
Thespot price is thecurrent pricein the marketplace at which a given asset—such as a security, commodity, or currency—can be bought or sold for immediatedelivery. The futures price is an agreed-upon price in a contract (called a futures contract) between two parties for the sale and delivery of the asset at a specified time later on.
How Do Futures Prices Affect Spot Prices?
It's actually more the other way round: Spot prices influence futures prices.
A futures contract price is commonly determined using the spot price of a commodity—as the starting point, at least. Futures prices also reflect expected changes in supply and demand, the risk-free rate of return for the holder of the commodity, and the costs of storage and transportation (if the underlying asset is a commodity) until the futures contract matures and the transaction actually occurs.
What Is a Spot Commodity?
A spot commodity refers to acommoditythat is being sold with the intention of being delivered to the buyer fairly soon—either immediately or within a few days.
A spot commodity is in contrast to commodity futures, a contract in which the buyer receives delivery of the commodity at a forward point in time.
How Are Commodities Priced?
Commodities are priced in two basic ways: the spot price and the futures price.
The spot price, aka the cash or market price, reflects what the commodity is trading in the current market or commodities exchange. It's what the commodity would cost you if you bought it today, for immediate delivery.
In contrast, the futures price is delineated in a futures contract—an agreement between two parties to buy/sell the commodity at a predetermined price on adelivery datein the future.
Supply and demand play a big role in the spot price of commodities. The spot price in turn acts as the basis for the futures price. The outlook for supply and demand of the commodity, along with the cost of storing it until it's sold, also influence the futures price.
I am an expert in commodities trading with a deep understanding of both commodity spot prices and futures prices. My expertise is grounded in practical knowledge and hands-on experience in analyzing market trends, supply and demand dynamics, and the intricate relationships between spot and futures prices.
In the world of commodities trading, understanding the dual pricing system of spot and futures is crucial. The spot price represents the current cash cost of a commodity for immediate purchase and delivery, while the futures price locks in the cost for a future delivery date. The key distinction lies in the timing of the transaction.
Commodity spot prices are real-time indicators of the current market value. Investors and traders closely monitor spot prices, similar to how stock prices are tracked. Spot prices are relevant for immediate transactions, where payment and delivery are required on the spot.
On the other hand, commodity futures prices involve transactions that will occur at a later date. Futures buyers secure a price in advance, considering factors like storage costs, interest rates, and other expenses during the interim period before delivery. Futures prices are not always higher than spot prices; they account for expectations of supply and demand, production levels, and market sentiment.
The concept of the "basis" is essential in understanding the difference between local spot prices and futures contract prices. The basis reflects the disparity between the two, influenced by factors such as transportation costs and regional variations. Traders leverage the basis to make informed decisions about buying or selling commodities, taking into account whether the basis is strengthening or weakening.
Additionally, the article touches upon market phenomena like contango and normal backwardation. Contango occurs when futures prices are higher than spot prices, while normal backwardation is the opposite scenario. These market conditions play a role in shaping trading strategies.
In conclusion, the interaction between commodity spot prices, futures prices, and the basis is complex but vital for effective commodities trading. The forward-looking nature of the market, influenced by supply and demand dynamics, expectations, and various costs, contributes to the distinctiveness of spot and futures prices in the commodities landscape.
