Understanding Prices

Understanding Futures Prices

 

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In this lesson we'll look at some of the factors that affect futures prices.  So, what makes futures prices rise and fall?  Futures prices are continuously in flux and move up or down due to the collective action of all traders in the market. 

Essentially, if there are more traders that want to buy than there are that want to sell then the price will rise.  Similarly, if there are more that want to sell than there are that want to buy then the price will fall.  Fundamentally, this is what causes futures prices to rise and fall - the trading actions of all futures market participants.

But, we must extend this logic and ask why traders would want to buy or sell.  Traders typically don't decide to buy or sell on a whim; they have a reason for wanting to do so. 

Their reasons for doing so are varied but generally fall under two categories: fundamental and technical analysis of the markets.  In short, futures traders evaluate information about the markets and then decide to buy or sell based upon their evaluations.  At root though, it is the actual buying and selling on the exchange floor that causes prices to move in one direction or the other. 

Beyond these basic consideration, there are several other factors that affect futures prices and how they are quoted in the marketplace.

Cash/spot prices

Many things affect futures prices, but one important element is the cash price of a particular commodity.  The cash price, or spot price, is the price that a certain commodity can be exchanged for on the open market.  If a buyer wanted to purchase wheat from a supplier in the present, the two parties could conduct their own private transaction on the open market instead of resorting to the futures market. 

The "going price" for the wheat on the open market is known as the cash price.  Cash prices and futures prices are highly correlated and generally move in tandem with each other.  The reasons for this are many and varied, but it is important to recognize this fact because the cash and futures markets mutually affect the prices of the other.

Normally, futures prices will be higher than cash prices.  The costs of storage and insurance for a commodity account for this premium of futures prices over cash prices.  The difference in these prices is callled the "basis".  This basis is something that is closely watched by hedgers and even spread traders. 

infoAt times, an imbalance in the basis is revealed in the markets, but this is rarely an opportunity for most futures traders.  Floor traders, who are close to the price action, usually become aware of these imbalances very quickly and profit from them long before the average trader learns about them. 

Price increments/tick value

Futures prices move in prescribed increments, called the tick value.  These increments are specific for each commodity and are determined by the exchange.  It is important to know a certain commodity's tick value before trading it because this is how a trader calculates potential profits and losses. 

For instance, the standard gold contract on the CME trades in increments of 10 cents- this is the minimum tick.  A trader cannot buy or sell gold contracts for 880.44 - acceptable prices would be 880.40, 880.50, etc.  Furthermore, this increment is quoted per troy ounce.  So, since the total contract size is 100 troy ounces, a price movement of one tick would equal a loss or gain of 10 dollars.

The bid/ask spread

A close look at commodity prices during trading hours reveals much about the bullish or bearish nature of that commodity.  The bid/ask spread is fundamental to understanding futures prices in an up-close way.  Basically, you will see two prices quoted above the current market price for any given futures contract. 

The bid price is the price at which some traders are offering to buy and the ask price is the price at which other traders are offering to sell.  This bid/ask data changes continuously and watching it closely gives an indication of the character and probable direction of market prices in the immediate future.