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.

RELATED TERMS
  1. Wide Basis

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

    On track is a commodity futures delivery deferred and priced ...
  3. Approved Delivery Facility

    Approved delivery facility is a location authorized by an exchange ...
  4. Physical Delivery

    Physical delivery is a term in an options or futures contract ...
  5. Full Carry

    Full carry occurs when when the later delivery futures contract ...
  6. Roll Yield

    Roll yield is the return generated by rolling a short-term futures ...
Related Articles
  1. 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.
  2. 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.
  3. Investing

    DBC: PowerShares DB Commodity Tracking ETF

    Find out about the PowerShares DB Commodity Tracking ETF, and explore a detailed analysis of the fund that tracks 14 distinct commodities using futures contracts.
  4. Trading

    How & Why Interest Rates Affect Futures

    There are at least four factors that affect change in futures prices, including risk free-interest rates, particularly in a no-arbitrage environment.
  5. 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.
  6. Trading

    Forward Contracts: The Foundation Of All Derivatives

    An investor can assess interest rate parity and implement covered interest arbitrage by using a currency forward contract to generate risk-free returns.
  7. Trading

    The Future Is Now: All About Futures ETFs

    A new security class - futures ETFs - is gaining popularity. We tell you how futures ETFs work and offer tips.
  8. Investing

    Currency Futures: An Introduction

    Find out why forex market is not the only way for investors and traders to participate in foreign exchange.
RELATED FAQS
  1. What's the best way to play backwardation in the futures market?

    Backwardation is a market condition in which a futures contract far from its delivery date is trading at a lower price than ... Read Answer >>
  2. What is the Difference Between a Forward Rate and a Spot Rate?

    The forward rate is the settlement price of a forward contract, while the spot rate is the settlement price of a spot contract. Read Answer >>
  3. What is the difference between trading currency futures and spot FX?

    The main difference between currency futures and spot FX is when the physical exchange of the currency pair takes place. Read Answer >>
  4. What's the difference between cash-on-delivery differ and delivery against payment?

    Find out more about cash on delivery and delivery versus payment transactions and the difference between these two types ... Read Answer >>
  5. What is the difference between arbitrage and hedging?

    Dive into two very important financial concepts: arbitrage and hedging. See how each of these strategies can play a role ... Read Answer >>
Trading Center