Convergence

What is 'Convergence'

Convergence is the movement of the price of a futures contract towards the spot price of the underlying cash commodity as the delivery date approaches. The two prices must converge, or else traders would exploit any price difference to make a risk-free profit. This trading activity would continue until the two prices converge.

BREAKING DOWN 'Convergence'

Convergence happens because the market won't allow two different prices for a commodity that is selling at the same time in the same place. These differences are illogical and not possible in an efficient market with willing buyers and sellers. If these price differences did exist on the delivery date, there would be something traders call an arbitrage opportunity.

Arbitrage

That the spot price of a commodity would equal the futures price on the delivery date is fairly straightforward: purchasing the commodity outright on Day X (paying the spot price) and purchasing a contract that requires delivery of the commodity on Day X (paying the futures price) are in essence the same thing. The latter just adds an extra step.

If these prices somehow diverged on the delivery date, there would be an opportunity for arbitrage, that is, to make a functionally risk-free profit by buying the lower-priced commodity and selling the higher-priced futures contract (assuming the market is in contango; vice-versa if the market is in backwardation).

Contango and Backwardation

If a futures contract's delivery date is several months or years in the future, the contract will often trade at a premium to the expected spot price of the underlying commodity on the delivery date. This situation is known as contango​. As the delivery date approaches, the futures contract will depreciate in price; in theory, it will be identical to the spot price on the delivery date. If this were not the case, then traders could make a risk-free profit by exploiting any price difference on the delivery date.

The principle of convergence also applies when a commodity futures market is in backwardation​, that is, when futures contracts are trading at a discount to the expected spot price. In this case, futures prices will appreciate as expiration approaches, equaling the spot price on the delivery date. Again, if this were not the case then traders could make a risk-free profit by exploiting any price difference.