Day #229: The A, B, C’s of Futures Trading

A student of mine recently commented to me about growing interest in silvers futures backwardation.  I realize that this is a more complex topic than what I normally discuss here, but I thought it might be a good opportunity to give folks an appreciation for a topic they might not otherwise encounter.  Before I can say much about what’s happening with silver, I’ll need to give you a little background.

A is for Asset

Futures contracts are a type of security called a ‘derivative’ because their value is derived from some other (underlying) asset.  That is, stocks are not derivatives because they represent partial ownership in a firm and therefore their value is directly related to that firm’s value.  The value of a futures contract, on the other hand, rises and falls based on the value of some other asset — like a firm, a group of firms or an ounce of silver.  When trading futures contracts, then, one of the first considerations is the choice of underlying asset.  There are many to choose from.  Some assets are considered ‘investment assets’ like stocks and bonds because they are held in investor portfolios in order to store wealth.  Other assets are considered ‘consumption assets’ like pork bellies or frozen concentrated orange juice because they are held for use in a manufacturing process or other tangible application.  Some assets — like gold and silver — have both investment and consumption characteristics, so their categorization depends upon the intentions of the investor.  A futures contract is an agreement to buy or sell the underlying asset at a predetermined price at a predetermined time.  That predetermined price is the price that both parties expect the asset to trade for in the future.  Therefore, the current futures price is an estimate of the expected future spot price.  This is why we often hear early morning news reports telling us about what is happening in the futures markets.  Futures markets open about an hour before the stock market and futures contracts on stock indices give an indication of what will happen when the stock markets open.  That is, if the futures contracts are trading at higher prices than the previous day, it means that investors think that stock prices will increase in the future and it is likely that this will be evident in opening stock market prices.

B is for Backwardation

Typically, futures prices are below the expected future spot price.  This is called normal backwardation.  As the futures contract gets closer to maturity, its price rises until it is equal to the spot price of the underlying asset.  If the futures price did not converge to the spot price at maturity, investors would be able to earn ‘free money’ due to this mispricing.  To see why this is true, assume that very near the end of the life of a futures contract, the futures price is less than the spot price.  An investor could buy the futures contract, (short) sell the asset and then use the proceeds from the short sale to take delivery on the futures contract to cover the short sale.  If the asset is trading at say, $20 and the futures contract is trading at $15, this series of transactions would result in a profit of  $5 (+20 – 15).   Here’s where this gets interesting.  Speculators aren’t interested in the underlying asset.  They just want to make money off of the futures contract.  Therefore, they will close their position before expiration by simply placing an offsetting order.  In the case of backwardation then, a speculator would hold a long position in the futures contract and offset it with a short position in order to close out his position.  If he takes his long position when the futures contract is trading for $5 and then closes it out when it is trading for $12, then he makes a profit of $7 (-5 + 12).  In precious metals, however, backwardation is less common because storage costs and insurance costs drive up futures prices.

C is for Contango

When the futures price is above the expected future spot price, the situation is known as contango.  This is the opposite of contango and therefore our speculator would typically execute a very different strategy than what I described when backwardation is present.  With contango, the speculator is expecting futures prices to go down in order to converge with spot prices.  Therefore, the speculator will take a short position in the futures contract when, the prices is high, take an offsetting long position when the price is low and earn a profit.  This all works just fine until markets get crazy and price patterns switch from exhibiting backwardation to exhibiting contango.  Such a change can make long speculators nervous and an opposite change will cause anxiety for short speculators.  There is a little bit of this craziness currently happening in the silver futures market.  While this market typically exhibits contango, it has now slipped into backwardation.  This is because silver prices have skyrocketed lately (see the price chart above) due to decreased supply and increased demand.  Given this unusual occurrence, traders are trying to figure out if it will persist and how they should adjust their trading activity.  Are their fortunes to be made in the silver futures market?  That’s tough to say.  Silver is a bit different than gold due to it’s higher volatility.  I’m not here to give investment advice, but the next time someone asks you what you think about silver, you can say that the shift from contango to backwardation is making it interesting, but the extent of its persistence is still questionable.  Depending on the crowd, it might be that no one will have a clue what you’re talking about, but it will sound impressive!  icon smile Day #229:  The A, B, Cs of Futures Trading

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