The futures market (part 8)

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The Futures market spreads (part 8)

In part 6, I wrote about Futures spreads.  How they are defined and how to trade spreads.

In part 7, I will cover how the margins are used in trading spreads.

I have spoken in an earlier editorial that with spreads we can buy a contract in one month and sell another in a different expiry (or delivery) month.

What if the price of the front month costs less than the price of the future month?  This can happen and we call this market “Contango Markets”.  If an ounce of Gold in May futures contract costs $1310 and an ounce of Gold in July futures contract is $1325, the market is in Contango.  It is a normal market if those prices are correct as the future month due to the cost of carry, which is made up of storage costs, insurance on stored commodity, and interest rates payments for the capital needed to own and store the commodity.

What if the price of the earlier month costs more than the future month?  This is not a normal market.  We call this market Backwardation.  Markets in Backwardation are also called “inverted” markets. Backwardation typically occurs during bull markets.

The principle of supply and demand comes into consideration.  When there is a substantial supply issue or increase in demand, the front months of a commodity will start to go up faster than the back months. The front months are more sensitive to changes in supply and demand because the front months are the commodity months that are coming to the market for deliveries. If there are supply decreases or demand increases, it is easier for the market to account for these in the deferred months, especially in the next crop year, also known as the “new crop”.

For example, let’s say it is July 2014 there is an increase in demand for the safe currency the world which is gold because of a war in Israel or a downing of the aircraft in the Ukraine. If the Gold supply cannot meet the increased demand, the price of the spot may be higher than the future price of Gold. This will create a higher price for the futures contract of Gold for the nearer month and market Backwardation is created, albeit for a short duration.