Page 134 - DCOM507_STOCK_MARKET_OPERATIONS

Unit 6: Trading Strategies

(d) Finance costs i.e., interest forgone on funds used for purchase of the commodity. Notes
Basis = Futures – Spot Price
Although the spot price and futures price generally move in line with each other, the basis is not
constant. Generally, the basis will decrease with time. And on expiry, the basis is zero and
futures price equals spot price. If the futures price is greater than the spot it is called contango.
Under normal market conditions futures contracts are priced above the spot price. This is known
as the contango market. In this case, the futures price tends to fall over time towards the spot,
equalling the spot price on delivery day. If the spot price is greater than the futures price it is
called ‘backwardation’. Then the futures price tends to rise over time to equal the spot price on
the delivery day. So in either case, the basis is zero at delivery. This may happen when the cost
of carry is negative, or when the underlying asset is in short supply in the cash market, but there
is an expectation of increased supply in future, for example agricultural products. The direction
of the change in price tends to hold for cycles of contracts with different delivery dates. If the
spot price is expected to be stable over the life of the contract, a contract with a positive basis will
lead to a continued positive basis although this will be lower in nearby delivery dates than in
far-off delivery dates. This is a normal contango. Conversely, normal backwardation is the
result of a negative basis where nearer maturing contracts has higher futures prices than far-off
maturing contract.
Figure 6.1: Futures Contracts – Contango and Backwardation

Simple Pay-off Positions in Futures: The buyer of a futures contract is said to ‘go long’ the
future, whereas the seller is said to ‘go short.’ With a long position, the value of the
position rises as the asset price rises and falls as the asset price falls. With a short position,
a loss ensues if the asset price rises but profits are generated if the asset price falls.

Buyer’s Pay-off: The buyer of futures contract has an obligation to purchase the underlying
instrument at a price when the spot price is above the contract price. The buyer will buy
the instrument for the price ‘C’ and can sell the instrument for higher spot price thus
making a profit. When the contract price is above spot price, a loss is made by the buyer of
the contract.
Seller’s Pay-off: The seller of the contract makes a profit when the contract price is above
the spot price. The seller will purchase the instrument at the spot price and will sell at the
contract price. The seller makes a loss when the spot price is above the contract price.

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