A:

It's a fairly safe bet that as the delivery month of a futures contract approaches, the future's price will generally inch toward or even come to equal the spot price as time progresses. This is a very strong trend that happens regardless of the contract's underlying asset. This convergence can be easily explained by arbitrage and the law of supply and demand.

For example, suppose the futures contract for corn is priced higher than the spot price as time approaches the contract's month of delivery. In this situation, traders will have the arbitrage opportunity of shorting futures contracts, buying the underlying asset and then making delivery. In this situation, the trader locks in profit because the amount of money received by shorting the contracts already exceeds the amount spent buying the underlying asset to cover the position.

In terms of supply and demand, the effect of arbitrageurs shorting futures contracts causes a drop in futures prices because it creates an increase in the supply of contracts available for trade. Subsequently, buying the underlying asset will causes an increase in the overall demand for the asset and the spot price of the underlying asset will increase as a result .

As arbitragers continue to do this, the futures prices and spot prices will slowly converge until they are more or less equal. The same sort of effect occurs when spot prices are higher than futures except that arbitrageurs would short sell the underlying asset and long the futures contracts.

To learn more about futures, see Futures Fundamentals.

RELATED FAQS
  1. What are some securities that have spot rates?

    Learn about the types of assets that have spot rates, and understand how the spot rate is used to determine the fair market ... Read Answer >>
  2. How can I calculate the notional value of a futures contract?

    Learn how the notional value of a futures contract is calculated, and how futures are different from stock since they have ... Read Answer >>
  3. What is the difference between forward and futures contracts?

    Fundamentally, forward and futures contracts have the same function: both types of contracts allow people to buy or sell ... Read Answer >>
  4. How do the investment risks differ between options and futures?

    Learn what differences exist between futures and options contracts and how each can be used to hedge against investment risk ... Read Answer >>
  5. What types of items can you buy futures for?

    Learn what items futures may be purchased for, what a futures contract is and discover how the futures markets have greatly ... Read Answer >>
  6. How are futures used to hedge a position?

    Futures contracts are one of the most common derivatives used to hedge risk. A futures contract is as an arrangement between ... Read Answer >>
Related Articles
  1. Markets

    Crude Oil Prices: Comparing Future Price Vs. Current Market Price

    Discover the differences between oil futures market prices and oil spot market prices and what leads to the differences between the two.
  2. Trading

    The Difference Between Forwards and Futures

    Both forward and futures contracts allow investors to buy or sell an asset at a specific time and price.
  3. Trading

    Why Is Arbitrage Trading Legal?

    Not only is arbitrage legal in the US and most developed countries, it can be beneficial to the overall health of a market.
  4. Investing

    Options on Futures

    Options on futures contracts offer another way for day traders to use options. These are traded on the same exchange as the underlying futures contract. Traders should take care to understand ...
  5. Trading

    Advantages Of Trading Futures Over Stocks (APPL)

    We look at the top eight advantages of trading futures over stocks.
  6. Investing

    What Does Spot Price Mean?

    Spot price is the current price at which a security may be bought or sold.
  7. Trading

    Futures, Derivatives and Liquidity: More or Less Risky?

    Futures and derivatives get a bad rap after the 2008 financial crisis, but these instruments are meant to mitigate market risk.
  8. Trading

    What's The Difference Between Options And Futures?

    An option gives the buyer the right, but not the obligation, to buy or sell a certain asset at a set price during the life of the contract. A futures contract gives the buyer the obligation to ...
  9. Markets

    How to Trade Futures Contracts

    Futures is short for Futures Contracts, which are contracts between a buyer and seller of an asset who agree to exchange goods and money at a future date, but at a price and quantity determined ...
  10. Investing

    Understanding the Spot Market

    A spot market is a market where a commodity or security is bought or sold and then delivered immediately.
RELATED TERMS
  1. Wide Basis

    A condition found in futures markets in which the spot price ...
  2. Convergence

    The movement of the price of a futures contract towards the spot ...
  3. Narrow Basis

    A condition found in futures markets in which the spot price ...
  4. Futures

    A financial contract obligating the buyer to purchase an asset ...
  5. Spot Delivery Month

    The nearest month when a futures contract matures. The spot delivery ...
  6. Reverse Cash-and-Carry-Arbitrage

    A combination of a short position in an asset such as a stock ...
Hot Definitions
  1. Diversification

    A risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique ...
  2. European Union - EU

    A group of European countries that participates in the world economy as one economic unit and operates under one official ...
  3. Sell-Off

    The rapid selling of securities, such as stocks, bonds and commodities. The increase in supply leads to a decline in the ...
  4. Brazil, Russia, India And China - BRIC

    An acronym for the economies of Brazil, Russia, India and China combined. It has been speculated that by 2050 these four ...
  5. Brexit

    The Brexit, an abbreviation of "British exit" that mirrors the term Grexit, refers to the possibility of Britain's withdrawal ...
  6. Underweight

    1. A situation where a portfolio does not hold a sufficient amount of a particular security when compared to the security's ...
Trading Center