Commodity and Index Futures

Why this matters

Many people who hold futures don't know it. They own a commodity fund, or a product described as tracking oil or gold, and expect it to rise and fall with the price they see quoted. Often it doesn't, because the fund holds futures, and futures have their own prices and their own costs. This lesson explains why, and covers the financial futures that sit behind much of the stock and bond market's daily trading.

The main kinds

FINRA's examples of commercial users are a cereal company buying wheat futures to secure prices and an airline buying energy futures.¹ The financial contracts work the same way, with one practical difference. Most commodity contracts contemplate delivery of the actual goods, and some allow cash settlement instead.² A contract on a share index can't sensibly deliver a slice of 500 companies, so such contracts are generally settled in cash: at expiration, the difference between the contract price and the index level is paid.

Where a futures price comes from

A futures contract reflects the expected value of the commodity on delivery in the future, while the spot price reflects its value for immediate delivery.³ The two usually move together, imperfectly, and they converge as the contract nears expiration.³ How far apart they sit before then depends on what it costs to hold the thing until the delivery date.

Financial futures: the cost of carry

Think of two ways to own a share index in three months. One is to buy the shares today, paying for them now and collecting their dividends in the meantime. The other is to buy a futures contract, paying nothing now except margin and receiving no dividends. If the futures price drifted far from the cost of the first route, traders would buy one and sell the other until the gap closed. So the futures price settles near the price today, plus the interest the buyer saves by paying later, minus the dividends they give up.

Futures price ≈ Price today × (1 + (Interest rate − Dividend yield) × Time)

Input	Value
Index level today	5,000
Interest rate	4% a year
Dividend yield on the index	1.5% a year
Futures price	5,000 × (1 + 0.025 × 0.25) = 5,031.25

The futures price is 31 points above the index. That isn't a forecast that shares will rise. It's the net cost of carrying the shares for three months, and it shrinks to nothing by expiration.

This is why a futures price above the spot price shouldn't be read as a prediction. For financial futures, it's mostly arithmetic.

Commodities: storage and convenience

For physical goods, the cost of carrying also includes storage and insurance, which push later contracts higher. Against that, having the actual goods now can be worth something extra when supplies are tight: a refinery that runs out of crude can't wait for next month's contract. Prices for contracts with different delivery dates can differ from each other and from the spot price,³ and the shape of those prices across delivery dates tells you which force is winning.

• Contango: contracts with more distant delivery dates cost more.³ Supplies are ample, and storage costs dominate.
• Backwardation: contracts with more distant delivery dates cost less.³ Supplies are tight, and having the goods now is at a premium.

The rest of this lesson is for members

Still to come in this lesson: Rolling, and why funds drift, When the price went below zero, the key takeaways, and 2 quiz questions with explanations.

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