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 is Fibonacci retracement, and where do the ratios that are used come from?

    Fibonacci retracement is a very popular tool among technical traders and is based on the key numbers identified by mathematician ... Read Full Answer >>
  2. What is a derivative?

    A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, ... Read Full Answer >>
  3. Do hedge funds invest in commodities?

    There are several hedge funds that invest in commodities. Many hedge funds have broad macroeconomic strategies and invest ... Read Full Answer >>
  4. Can mutual funds invest in options and futures? (RYMBX, GATEX)

    Mutual funds invest in not only stocks and fixed-income securities but also options and futures. There exists a separate ... Read Full Answer >>
  5. What are some of the most common technical indicators that back up Doji patterns?

    The doji candlestick is important enough that Steve Nison devotes an entire chapter to it in his definitive work on candlestick ... Read Full Answer >>
  6. Tame Panic Selling with the Exhausted Selling Model

    The exhausted selling model is a pricing strategy used to identify and trade based off of the price floor of a security. ... Read Full Answer >>
Related Articles
  1. Trading Strategies

    Mastering Short-Term Trading

    The proper application of a few different tools can help a short-term trader succeed.
  2. Options & Futures

    How To Buy Oil Options

    Crude oil options are the most widely traded energy derivative in the New York Mercantile Exchange.
  3. Investing Basics

    Free Cash Flow Yield: A Fundamental Indicator

    Free cash flow can measure a business’s performance as if you’re looking at its net income line.
  4. Technical Indicators

    Four Commonly Used Indicators In Trend Trading

    No single indicator can punch a ticket to market riches, but here are four that remain popular among trend traders.
  5. Active Trading Fundamentals

    4 Stocks With Bullish Head and Shoulders Patterns for 2016 (PG, ETR)

    Discover analyses of the top four stocks with bullish head and shoulders patterns forming in 2016, and learn the prices at which they should be considered.
  6. Chart Advisor

    Uptrending Stocks Dwindle, a Few Remain (EW, WEC, WR)

    The number of uptrending stocks is shrinking, but here a few that remain in uptrends.
  7. Chart Advisor

    Trade Setups Based on Descending Trend Channels (LBTYK, RRC)

    These descending trend channels have provided reliable sell signals in the past, and are giving the signal again.
  8. Chart Advisor

    How Are You Trading The Breakdown In Growth Stocks? (VOOG, IWF)

    Based on the charts of these two ETFs, bearish traders will start turning their attention to growth stocks.
  9. Chart Advisor

    Breakout Opportunity Stocks: CPA, GNRC, WWE

    After a period of contracting volatility, watch for breakouts and bigger moves to come in these stocks.
  10. Options & Futures

    What Does Quadruple Witching Mean?

    In a financial context, quadruple witching refers to the day on which contracts for stock index futures, index options, and single stock futures expire.
RELATED TERMS
  1. Golden Cross

    A crossover involving a security's short-term moving average ...
  2. Warrant

    A derivative that confers the right, but not the obligation, ...
  3. Swap

    A derivative contract through which two parties exchange financial ...
  4. Cup and Handle

    A pattern on bar charts resembling a cup with a handle. The cup ...
  5. Dead Cat Bounce

    A temporary recovery from a prolonged decline or bear market, ...
  6. Hedge

    Making an investment to reduce the risk of adverse price movements ...
Hot Definitions
  1. Harry Potter Stock Index

    A collection of stocks from companies related to the "Harry Potter" series franchise. Created by StockPickr, this index seeks ...
  2. Liquidation Margin

    Liquidation margin refers to the value of all of the equity positions in a margin account. If an investor or trader holds ...
  3. Black Swan

    An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult ...
  4. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  5. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
Trading Center