For some people the stock market remains a world of unpredictable activities that they back off from it. But you can nail it by being vigilant and knowing the basics of trading. This article sheds light on Spot and Futures market and the relationship between them.
Spot price is the current price at which a particular stock can be bought or sold at a specified time and specified place. For example, spot price of Tata Steel Ltd in NSE is Rs. 247.60, EoD 29th Oct, 2015.
Futures price is the forecasted or expected value of the stock with relation to its present spot price at a specified place and specified time. For example, Tata Steel Ltd- Future Nov 26th, 2015 is Buy (Long) Rs. 248 and Sell (Short) Rs. 247
Relationship between Spot and Futures prices
The ‘Cost of Carry’
This cost is the difference between the Spot and Futures price. In simple terms, Cost of carry is the cost associated with holding the physical commodity (E.g. Sugar, Oil) or virtual (E.g. Shares) for a specified period like the cost of inventory, insurance, interest, etc. It is a financial cost that is incurred due to an investment position of an investor.
Contango
When the futures price for a commodity or share is higher than the spot price, it is known as Contango.
Backwardation
When the futures price for a commodity or a share is lower than the spot price, it is known as Backwardation.
The Spot-Future Parity
The Spot-Future parity condition is that if an asset, say a share is purchased today and held until the futures is exercised, the value of the future should equal the current spot price which is adjusted for the cost of money (time value of money), the dividends and convenience yield (Adjustment to cost of carry) ,if any.
This situation is what should normally happen, but in case it doesn’t, opportunities for arbitrage pop up. For example, if I buy BIOCON shares today for Rs 450 and enter into a contract to sell it one month from today for Rs 453, the difference in price, Rs 3 should not be greater than the cost of using money less any expenses (or earnings) from holding the asset. And if the difference is greater than Rs 3, I would have an opportunity to sell the shares for a risk-free profit that leads to arbitrage. There is a huge scope of arbitrage, in case the futures contract is mispriced and the underlying asset is non-perishable.
In a perfect and stable market scenario, neither the buyer nor the seller will opt for futures trading, as things are predictable. If one could forecast the future price of a share or a commodity, the very idea of futures market would disappear. It is thus the volatility of the markets and the element of uncertainty that gives birth to the futures market.
Recommended Read :
- What is a Derivative?
- What are Futures How to Trade in Futures?
- What is Put Call?
- What is Intrinsic Value?
- How can Derivatives protect your Stock Investment?
- What is Hedging?
- Difference Between Hedging and Speculation
- What are Stock Index Futures?
- Insuring Stock Portfolio with Protective Put
- What are Futures - How to Trade in Futures?
- What are Stock Index Futures and How to Use Them?
Thank You Gayathri. I have been wanting to invest in stocks/shares for quite some time now and i am trying to gather every bit of information i need, to understand the day to day jargons to ensure that i don’t incur high loss. I know investing in shares has its own risk but the loss shouldn’t be to an extent that one cannot recoup. While going with the flow, people usually forget about the long term risks and may not even pay attention to future price. This article has been very helpful for me to understand the complexities involved and am sure there is more for an individual to learn. Keep educating because for a commoner it’s essential to know the do’s and don’ts.
Yes Nirali…. Stock markets can be very tricky. It’s advised to start slow, simple and steady. As time goes by, one can try different instruments including derivatives. But, the ultimate decision is yours. Be well informed and vigilant. All the best!
Hey Gayatri, thank you for trying to be as simple as possible. However i still am not very clear with the concept. Could you help me out with the following questions?
1. When i buy futures, do i pay the future price or current price for the stock?
2. After my futures contract is over, do i need to compulsorily sell my stocks?
3. On the day of selling, if the price is higher than the predicted price, than how to go about the transaction?
Hi there… I am happy to know that you find my article helpful. All the questions that you asked are totally valid from the perspective of a new investor. I will cover them in my article on ‘expiration of futures’ that I am planning to write soon. This limited space is not enough to cover a vast topic as that. Till then… Keep reading!!!!
This article really has some handy information that can be useful for people trying to invest in the stock market for the first time. I came across many such terms of which I was completely unaware of. Such kinds of information are rather necessary if you plan to invest in a stock market.
As you rightly said Shraddha, new investors will be unaware of these jargons. But gradually you learn. And you will be amazed to know that there are umpteen ways by which you can make money in stock markets. These little informations just come in handy.
No wonder, man always wanted to know what lies in the future and in this case too it is the same. When he invests in a market, he starts estimating from the same day, as to what amount his investment is going to turn into. This article very effectively describes the difference between spot and future price. Really, a great effort towards educating a beginner who is going to invest in the stock market. Great work!!
Yes Garima, you are right! Unlike banks, stock markets are quite unpredictable. One must be very sure of his/her moves. Thanks for reading!!
This is so interesting. For someone who hasn’t been traded stock market it gives me a really good idea of what kind of profits I can expect and why - if I invest in shares.
All of these articles are really well written and show me how I can make money without really lifting a finger!
I just hope one day I can turn my futures into solid money! Thanks for the information!
The article explains everything here and what remained I just found out in the comments.Thanks to the writer for answering in an easy manner.Neat discussion for Expected price-the Futures price against the present price-the spot price. Well above just good.
Hey Gayatri , thanks for enlightening article !!!! For those who have been wanting to know the future price , you have cleared out every doubt. Even though the volatility and changing market trends prove a hurdle, spot and future prices set up is totally depending on them.These factors are responsible for profit making as the unpredictability plays an important role in estimation of future prices.
Hence Gayatri has put together a concise article about future & spot prices without adding any unambiguous information.Kudos !!!!