How are Futures Prices Determined?

Read our Advertiser Disclosure.
Contributor, Benzinga
March 24, 2021

If you want to start trading futures or switch brokers, visit NinjaTrader.

Greed, for a lack of a better word, is good.

Although you might not be conscious about it, you owe many modern amenities to greed. Futures contracts fall into that category.

Originating in the Tulip mania in the Netherlands, the first futures market was the Dojima Rice Exchange in 17th century Japan.

Yet, it wasn’t until the mid-19th century that the term “futures contract” appeared on the Chicago Board of Trade (CBOT). Originally these were between the commodity suppliers and commodity dealers, but speculator traders saw the opportunity. After all, their participation is providing the key element to any market – liquidity.

What are Futures Prices?

Futures are derivative financial contracts tied to an underlying asset. They bound the parties to transact the asset at a predetermined future date and price, regardless of the spot market price at the expiration date.

Futures were a highly beneficial invention for all the parties:

  • Suppliers: Having a demand guarantee for the product before committing to production
  • Dealers: Locking the cost structure months in advance
  • Traders: Engaging in lucrative transactions based on informed speculation

Originally futures were tied to agricultural commodities like rice, corn or cotton. Currently, the most liquid futures are 10-year government bonds, ES (S&P 500) and crude oil futures.

Nowadays, futures are often used to hedge the risk of unfavorable price movements — particularly useful for those who had to hold the underlying asset on their books.

Although they might seem similar, you have to understand the significant difference between futures and options. A futures contract is a buyer’s obligation to buy an asset (when held at expiry) and the seller’s obligation to deliver that asset at a specific future date. So, options are not binding the buyer to the transaction but allow facilitating the transaction if wanted.

Examples of Futures Prices

Understanding futures prices is the easiest through a historical example.

During the COVID-19 pandemic, NYMEX WTI crude oil futures went as low as -$36.98 per barrel. For the first time in history, oil owners would pay you to take it off their hands.

There are 3 things you have to know to understand why:

  • Supply: Due to OPEC disagreement, there was no further restriction of global production
  • Demand: Diminishing due to a global pandemic
  • Storage and delivery: Finite capacity in Cushing, Oklahoma

While the world was heading into the pandemic, the oil demand collapsed due to a lack of business activity. Yet, OPEC couldn’t reach a new agreement and there was no restriction on supply.

Meanwhile, storage facilities were running out of space. All of the NYMEX West Texas Intermediate (WTI) contract was delivered at Cushing.

On Friday, April 17, 4 days before the settlement date, open interest was 108,593 contracts representing 108,593,000 barrels for the May delivery. Yet, the remaining available capacity at Cushing was around 17,300,000 barrels.

With just 2 trading days left, speculators held 6 times more oil (delivering in 1 month) than there was available storage at the present moment! The only way to avoid the delivery was to close the contract, effectively taking a counterbalance short position. However, that would imply finding a buyer — and those were few and far between.

img_605b5a3ae8706

Crude oil crashing below zero, Source: Fred

Holding a buy contract became a quintessential financial hot-potato, and the negative settlement represented the price the speculators were paying to have that barrel of oil stay in the ground. After the dust settled, open interest stood at 13,044 contracts — low enough for available storage capacity. The price returned to positive territory.

Formulas for Calculating Future Prices

Futures prices depend on the spot price of the underlying asset, adjusted for time and dividend accrued till the contract expiry.

How are futures prices determined?

Futures price = Spot price x (1 - rt) – d

  •  rt = the risk-free rate, like government treasury
  •  d = dividend

By scaling the risk-free rate proportionately, you arrive at a more generic formula:

Futures price = Spot price x [ 1 + rt x (x/365) - d]

  • x = number of days to expiry

By using this formula, you will arrive at the fair value price of the future. Yet, this doesn’t guarantee that price on the market. The price may deviate from fair value due to supply or demand and other factors.

Benefits of Forecasting

Futures prices reflect market expectations. Forecasting those expectations opens up both hedging and speculative possibilities, especially when discovering deviations from fair value. Although a large deviation might result in an arbitrage opportunity, remember — the market can stay irrational longer than you can stay solvent!

Best Future Markets to Trade

There are 3 key attributes to look for when deciding what futures market to trade:

  • Contract size (margin): Futures margins are lower than equities day-trading requirements. Contracts can be in standard, e-mini or even micro e-mini size, each holding a smaller dollar value. Micro-sized contracts can have margins as low as $50.
  • Liquidity: Trading the highly liquid market is easier because your actions will have a smaller impact on price. This is particularly important in day trading.
  • Volatility: The greater the volatility, the higher the opportunities to profit. Volatility impacts your risk-to-reward ratio, but choosing a volatile market ultimately depends on your strategy.

Based on these conditions, some of the best futures markets to trade are:

  • S&P 500 E-Mini: These are the most liquid futures market in the world — a cost-efficient way to gain market exposure to S&P 500.
  • Crude oil: Trades close to 1.2 million contracts per day; crude oil futures are a very volatile market, attracting both hedges and speculators.
  • 10-year T-Notes: U.S. Government bonds are the most sought-after fixed income securities in the world. There is (almost) never a shortage of market participants that need to hedge their exposure to U.S. debt, providing for an extremely liquid market.
img_605b5a3eca1f2

Top futures markets by liquidity, source: CME

Best Online Futures Brokers

You will need a broker account to trade the futures. Check our overview of the best online futures brokers in the table below. You can also check our guide on how to trade futures.

  • NinjaTrader
    More Details
    Best For
    Advanced Futures Trading
    Overall Rating
    Read Review
    securely through NinjaTrader's website
    More Details
  • Tradovate
    More Details
    Best For
    High-volume Traders
    Overall Rating
    Read Review
    securely through Tradovate's website
    More Details
  • Discount Trading
    More Details
    Best For
    High Volume Traders
    Overall Rating
    Read Review
    securely through Discount Trading's website
    More Details
  • Optimus Futures
    More Details
    Best For
    Trading Micro Futures
    Overall Rating
    Read Review
    securely through Optimus Futures's website
    More Details

For you with an interest in online courses, check our outlook of the best futures trading courses.

Back to the Futures

Whether your goal is to hedge or to speculate — futures present a cost-effective way to gain leveraged exposure in some of the largest markets in the world. Yet this does not come without dangers. Given the leverage and volatility, the losses incurred on the futures market can be soul-crushing. Many naïve traders learned that in April 2020 as they didn’t realize that futures can have a negative price.

No matter what your goal is, always thoroughly study the asset before you trade it and use a risk management strategy.

Frequently Asked Questions

Q
Do futures prices predict spot prices?
A

Not always. Futures forecasting will depend on whether the commodity is non-storable, storable with large inventory or storable with a modest inventory. For example, non-storable commodities like eggs will not impact the spot price because they cannot be taken out of the market for future use.

Q
Why are futures prices higher than spot prices?
A

This is due to the costs of carry — generally involving all the expenses that an investor foregoes over a period of the contract. Examples are physical storage, insurance or spoilage.

Futures prices are generally higher than spot prices, but as seen in the WTI crude oil example, it is not always the case.

Q
What is the difference between the spot price and futures price?
A

The difference is in the delivery date. A spot price is a price for immediate delivery of the commodity (on the spot). The futures price is the price quoted for delivery at a specified future date. The difference between the spot and futures price is called the basis.