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. 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 >>
  2. What is the difference between a forward rate and a spot rate?

    Learn about spot and forward contracts, how spot and forward rates are used for spot and forward contracts, and the difference ... Read Answer >>
  3. How do I set a strike price for a future?

    Find out why futures contracts don't have set strike prices like options or other derivatives, even though price change limits ... Read Answer >>
  4. How can a futures trader exit a position prior to expiration?

    A futures contract is an agreement to buy or sell a commodity at a pre-determined price and quantity at a future date in ... Read Answer >>
  5. What are common factors that affect a security's spot rate?

    Learn the common factors influencing the spot rate for an asset including the bid-ask spread and the forward term structure ... Read Answer >>
  6. How is the price of a derivative determined?

    Learn how different types of derivatives are priced, including how futures contracts are valued and the Black-Scholes option ... Read Answer >>
Related Articles
  1. Investing

    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

    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.
  3. 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.
  4. Trading

    Combining Forex Spot And Futures Transactions

    The spot, futures and option currency markets can be traded together for maximum downside protection and profit.
  5. Trading

    What Does Spot Price Mean?

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

    Understanding the Spot Market

    A spot market is a market where a commodity or security is bought or sold and then delivered immediately.
  7. Investing

    Is USO a Good Way to Invest in Oil?

    The United States Oil Fund is better suited to short-term investors who actively manage their portfolios.
  8. Investing

    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 ...
RELATED TERMS
  1. Wide Basis

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

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

    The movement of the price of a futures contract towards the spot ...
  4. Futures

    A financial contract obligating the buyer to purchase an asset ...
  5. Reverse Cash-and-Carry-Arbitrage

    A combination of a short position in an asset such as a stock ...
  6. Spot Delivery Month

    The nearest month when a futures contract matures. The spot delivery ...
Hot Definitions
  1. Frexit

    Frexit – short for "French exit" – is a French spinoff of the term Brexit, which emerged when the United Kingdom voted to ...
  2. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
  3. Down Round

    A round of financing where investors purchase stock from a company at a lower valuation than the valuation placed upon the ...
  4. Keynesian Economics

    An economic theory of total spending in the economy and its effects on output and inflation. Keynesian economics was developed ...
  5. Portfolio Investment

    A holding of an asset in a portfolio. A portfolio investment is made with the expectation of earning a return on it. This ...
  6. Treynor Ratio

    A ratio developed by Jack Treynor that measures returns earned in excess of that which could have been earned on a riskless ...
Trading Center