Things to Consider in Futures Pricing
Divergence in futures price and spot price is mainly due to interest rates and expiry dates. This variance between these two forms the ‘basis of spread’. The spread is the maximum at the start of the series but gradually converges as the settlement date nears. Here spread refers to the difference between the spot and the futures price.
The spot price and futures price are almost equal on the expiration date.
Things to Understand in Futures Pricing
Here are certain aspects that individuals should understand regarding futures pricing:
Buying and Selling Futures Contracts
Contracts are legal agreements between a buyer and a seller. For example, a buyer may take a long position in future, whereas a seller may take a short position.
Margin is the amount of money deposited by both parties with stockbrokers at the beginning of a trade. It acts as an assurance that both parties will honour their commitments on contract expiry. If the initial amount falls below the maintenance amount, the parties may receive a margin call.
Also read How to Trade in Futures and Options
Mark to market is a process to settle futures prices daily. Futures’ prices may see a rise or fall in their value due to active trading throughout the day. Mark to market calculations is done daily after the closing of trading hours. Clearinghouses pay the price differences daily.
The P&L account is credited and debited with the differential amount from the margin deposited with clearinghouses on the same day.
Different Future Pricing Models
Two types of future pricing models are given below:
It assumes that markets are perfectly efficient. This means no difference between spot and futures prices, and it thereby eliminates any chance of arbitrage. Arbitrage is a process by which traders take advantage of a price difference in two markets.
Under this model, traders are indifferent towards both markets as their earnings are the same from both. Futures price will be equal to spot price plus the net cost of carrying the assets till expiry.
Therefore, Futures pricing = Spot pricing + (Carry cost – Carrying return)
Here carrying costs may include storage costs, interest paid to acquire assets or financing costs. Carrying returns will include any income earned with these assets, like dividends and bonuses. The net of these is the net carrying cost.
This model is based on expected pricing trends. Futures pricing of an asset is what the expected spot price will be in future. Futures prices will be positive if markets are bullish, whereas pricing will be negative if markets exhibit bearish sentiments. In this model only, the expected future spot price is taken into consideration.
Final Word
Futures pricing is dependent on various factors like interest, returns, and financing costs. One should understand how futures pricing works to plan their position in markets more efficiently.
FAQs
A futures price is determined by the cost of its underlying asset and moves in sync with it. The cost of futures will rise if the cost of its underlying increases and will fall as it falls. But it is not always equal to the value of its underlying asset.
How are futures prices determined? ›
A future price is measured by the moves in sync and the cost of the underlying asset. If the cost of underlying increases, the cost of futures will rise and if it decreases, the cost of future will fall.
What are the factors responsible for the pricing of futures? ›
Interest rates are one of the most important factors that affect futures prices; however, other factors, such as the underlying price, interest (dividend) income, storage costs, the risk-free rate, and convenience yield, play an important role in determining futures prices as well.
What are the basic concepts in future pricing? ›
Futures price will be equal to spot price plus the net cost of carrying the assets till expiry. Here carrying costs may include storage costs, interest paid to acquire assets or financing costs. Carrying returns will include any income earned with these assets, like dividends and bonuses.
What are the determinants of value of futures contracts? ›
Spot Price and Cost of Carry
The price of a futures contract is primarily influenced by the spot price of the underlying asset. The spot price refers to the current market price of the asset being traded.
What is the 80% rule in futures trading? ›
Definition of '80% Rule'
The 80% Rule is a Market Profile concept and strategy. If the market opens (or moves outside of the value area ) and then moves back into the value area for two consecutive 30-min-bars, then the 80% rule states that there is a high probability of completely filling the value area.
Are futures prices determined by supply and demand? ›
Since many futures represent commodities that do not have a continuous, supply like corn, or commodities that are in higher demand at certain time of the year, like heating oil, these seasonal patterns of supply and demand create natural cycles that influence the price of futures contracts.
What are the 4 factors to be considered in pricing? ›
Determinants of Price in Marketing
Product Cost. The Utility and Demand. The extent of Competition in the market. Government and Legal Regulations.
What are the three main factors that influence pricing? ›
Customers, competitors, and costs influence prices through the demand and supply.
Can futures price be lower than spot? ›
A market is "in backwardation" when the futures price is below the spot price for a particular asset. In general, backwardation can be the result of current supply and demand factors. It may be signaling that investors are expecting asset prices to fall over time.
A futures price is determined by the cost of its underlying asset and moves in sync with it. The cost of futures will rise if the cost of its underlying increases and will fall as it falls. But it is not always equal to the value of its underlying asset. They can be traded at different prices in the market.
What is basic futures strategy? ›
Long: Buy futures and profit when the prices increase. Short: Sell futures contracts and profit when the prices decrease. Spread: Simultaneously buy different futures contracts and profit when the relative price difference widens (or narrows).
What are the concepts of futures? ›
A future is a contract to buy or sell an underlying stock or other assets at a pre-determined price on a specific date. On the other hand, options contract gives an opportunity to the investor the right but not the obligation to buy or sell the assets at a specific price on a specific date, known as the expiry date.
What determines the price of a futures contract bought or sold? ›
Pricing via expectation
Here the price of the futures is determined by today's supply and demand for the underlying asset in the future.
What is the difference between future price and future value? ›
The futures price is fixed at the start, whereas the value starts at zero and then changes, either positively or negatively, throughout the life of the contract.
What indicators to use for futures trading? ›
Indicators like Volume Profile HD, Supertrend, RSI, and Bollinger Bands provide deep market insights, crucial for navigating the swift currents of futures markets. Whether it's identifying market trends, assessing volatility, or making quick, informed decisions, these tools are invaluable for any futures trader.
Do futures accurately predict market? ›
Index futures do predict the opening market direction most of the time, but even the best soothsayers are sometimes wrong.
Why are futures prices higher than spot prices? ›
It indicates that demand is higher than supply in the short term, causing futures prices to rise. Futures prices rise above spot prices because investors become comfortable paying more for the future assets. However, commodity and volatility funds are structured to buy short-term futures.
Do futures prices predict spot prices? ›
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.
