Do Future and Spot prices ALWAYS converge at expiration?

CFA Level I Derivatives
#1

Hi, First post.
I’m looking at the term structure for commodity futures and I’m confused in regards to the price that the future expires at.

Lets take Natural Gas spot and DEC23 future as an example.
The Spot price is currently 3168 and the DEC23 future is 3054. A Basis of 114 points.
My understanding to date is that the future price should eventually converge to the spot price and upon expiration, they should be equal (more or less) and the basis should become 0 or close to it.
If that is correct then the position above is technically an arbitrage scenario.

My confusion came up when testing something where I went short on the spot market and long on the future.
The short spot position was paid overnight (daily) and although the basis did weaken (from 80 points to 35), there was still a 35 point gap at expiry. (<- This was the Nov23 future.)

So my question is:
Is my understanding above correct? Should the Future and Spot prices converge when the future expires or is that a “It should but might not” scenario?

Thanks

#2

It’s always true . . . in the world where the futures contract is marked to market an instant before it expires.

1 Like
#3

Thanks for the reply @S2000magician although I can’t tell if your comment is sarcasm or not :sweat_smile:
The platform I’m testing on had the Nov 23 future expiring at 812.75 (which matches ICE exactly) but the undated closed at 797.70 leaving a 15.05 basis upon expiry. I would have expected the undated to also be 812.75 at that time.
I’ve been reading a lot about the basis strengthening or weakening during the life of the future but I’ve not much is said about the basis upon expiry. Just that it “should” converge with the spot market not that it “will”

#4

Covergence is theoretical.

Questions: is the differencce able to be arbed.?Are there reasons why an arb at those prices is unpofitable or not practical. I don’t know enough about the market you are talking about but commodity futures are particlaly tricky due to the ability/cost to go short/long the underlying.

Once you have removed all that.

Basis can be used in very liquid markets to see how much lquidity there is in the financial system. Very low interest rates, excess liquidity and below look for abs. Tight financial markets there is not as much luqidity in these markets.

#5

No sarcasm.

If the futures were marked to market every instant, then the futures price would always converge exactly to the spot price.

In the real world, where the mark-to-market is not continual, there will likely be some difference.

1 Like
#6

So I got in when there was a ~100 point basis so the convergence to date was definitely profitable plus the nightly payments exceeded the amount I made on the basis weakening.
My question is more around the remaining 15 point basis when the future expired.
Should I be expecting the pair to completely converge or expect that it will converge but may not “completely” close once it expires?

#7

Is “15” within the “profitable tradeable range”

If you are fully hedged with the correct underlying just let it expire.

#8

Thanks for your replies.

I’m UK based and the platform in use is actually CFD based and not “proper” futures via a clearinghouse.

That platform doesn’t mark to market at all from what I can see and is just continual. Profits/losses aren’t realised on the account until manual closure of the position, Rollover, or Expiry of the contract.

The “future” offered does track the exchange equivalent and the final expiry price is the official close price on NYMEX on the last trading day. Despite multiple posts on their forums and helpdesk tickets, I’ve yet to get a reply saying what their undated/spot/cash offering tracks or how it’s calculated.

I’m currently trying to work out if a trade would be profitable but struggling to find information on what the process is for certain positions closing/expiring. Essentially, I’m trying to do a carry trade with Natural Gas and other commodities.

For example, I have a current position on Natural Gas:
position

I currently receive an overnight payment based on the price of the current future vs the next future and how long is left on each (I would be paying this if I was long the cash position):
Daily Financing Adjustment - Commodities Basis for 1 day Natural Gas

daily
daily886×391 119 KB

From my basic understanding I have this:
Go short on the cash position and long on the future position.
Benefits
  • A profit should be made from the current 97 point basis weakening which is likely to happen before expiry.
  • Should receive positive daily payments based on front/next future prices.
Risks
  • The basis between DEC23 and CASH strengthens and stays that way until expiry (which shouldn’t be possible/probable). (The basis has currently strengthened from 97 to 135)
  • The basis between the current and forward future contracts (DEC23 and JAN24) strengthens resulting in reduced or negative daily payments.
  • The broker increasing their margin requirements during high volatility events.

I’m looking to confirm if my understanding of the benefits and risks is correct:

  1. Is there a high probability that the basis gap will weaken/close prior to, or at expiry?
  2. Is my understanding of the daily payments correct – they are effectively the “cost of carry” and not some adjustment making up for the basis not closing?
  3. Are there any other risks that I haven’t listed above that you think I should be aware of?
#9

On my very superficial reading

So it does not seem on the face of it an easy to arb spot gas and future.
Could you not look historically and see if the future has expired at the cash price they quote.

I really don’t understand the rest of it?

Is the equation (p3 - p2)/(t2 - t1).

If long dated future is in backwardation to the near future this amount will be negative.

Are sayng becuase you are short in the cash market you get (p2 - p3)/(t2 - t1).

Why do you recieve this?

The only way you get paid?
Or do you settle the long future short cash market at expiry? IIF so is the gain here offset against the gain on what you received on “daily financing adjustment”?

If so it seems link you are playing a trade on the relative basis chnage between the “spot and near future” and “near future and far future”.

But from your explanation I can’t work it out.

Rule of finance = don’t invest if you don’t underrstand

Ruke of poker - if you sit down to play and you don’t know who the patsy is, its you

#10

Thanks Mikey. This is all on demo - no actual funds have been traded here.
I’m trying to learn this but what I’m reading (from multiple sources) isn’t congruent with what is actually happening. EG, the image below is everywhere and the convergence of spot and future seems to be a recurring theme in every piece of literature I’ve read. EG, both of these examples below suggest that the convergence is more of a certainty than a probability:

In its simplest form my thought was
“There must be some way to profit from the basis between spot and future knowing that eventually they will both converge”.

image
image1013×587 49.9 KB

Sell the future, buy the spot, knowing that the gap between them should narrow/close entirely

I wouldn’t really care which way the market goes as I’d be hedged (other than the risks I posted above like the gap widening, etc).

Now, from my understanding, the image above would not be profitable as the overnight fees you would pay on the LONG spot position would equal or exceed any profits you would make on the basis narrowing/closing.

However, when in backwardation and the SPOT price > Front Future so:
IMAGE B

image
image1013×587 49.1 KB

You receive the overnight payments (as I’m selling the spot).

So my current understanding is that I should be able to profit from image B in two ways:

  • Receive overnight payments due to the SHORT SPOT position.
    This will positive while the Far Future>Front Future. If Far Future<Front Future, this will be negative.

  • Hold both positions (Short spot and Long future) open and profit from the narrowing/closure of the gap/basis as expiry approaches.
    I don’t care if they go up or down, just that the gap between Spot and Front future converges or narrows.

To answer your questions:

1. Why do you receive the payment?
It’s effectively a synthetic “cost-of-carry”.
In the brokers words: Commodities might incur cost of carry charges for the transport, storage and insurance of the asset – assuming that a trader takes ownership of the commodities which they have a position on.
Derivatives such as CFDs incur cost of carry as overnight funding fees. At IG, we make an interest adjustment to your account to reflect the cost of funding your position. We debit your account if the position is long, and we credit your account if the position is short.

2. The only way you get paid?
The only way I get paid is when I close the trade or let it expire which is when all profits/losses will be crystalised on the account. With the exception of the overnight credits which are automatically credited each night. (I only target markets where I take a short position in the SPOT market and the Far future>Front Future).

3. If so it seems link you are playing a trade on the relative basis change between the “spot and near future” and “near future and far future”.
Exactly. My overnight payments are determined by the front future vs far future and the basis between the spot & front future.

So the perfect storm would look like:

image
image1013×587 51.3 KB

So if the gap between Spot and DEC23 was 30 points with 10 days till expiry and the DEC23 expired at the spot price, I would profit 30 points + 10 overnight payments (variable based on rates and front/far future prices).

Other than the following risks, I cant see any problems:

  • The DEC23 does not expire at the spot price and the 30 point basis/gap remains - or worse, the basis between SPOT and DEC23 expands.
  • The JAN24 future price goes lower than the DEC23 future price (this will cause my nightly payments to become negative).

Thanks.

#11

Are you saying that.

You as the far future is in backwardation on the near future.
Account balance increase

AND
you gain profit on the closing of the difference in the cash position and near future

FF - far future
NF - near future

IF so you are earning
(FF - NR) + (NR - S)

= FF - S

I am not sure on the platform you are on using the instruments you have the NR and S have to converge as there is nothing making them happen
In commodity futures you can use the actual commodity to settle the future. Or use the future to settle you cash position. Here I don’t think that is feasible.

Also if the equation above is true you are not playing FF vs Sport.
There is nto natural arb causing this to close the expiry date of the near future.

#13

I am not sure on the platform you are on using the instruments you have the NR and S have to converge as there is nothing making them happen
In commodity futures you can use the actual commodity to settle the future. Or use the future to settle you cash position. Here I don’t think that is feasible. :pensive: :pensive: :frowning_face: :frowning_face: :face_holding_back_tears:

#14

I’m currently trying the same approach with CapitalCom (CFD broker, I’m in Europe).
Natural Gas spot price is 3,153, front month (NGF2025) is 3,264.

CapitalCom only offers the next two futures (now Jan and Feb) to trade.
I trade with leverage (10:1) and because of that, the broker charges me daily interests on the loan (called Overnight Fee), however that daily interest is a tool the broker uses to motivate traders to take certain positions.

Every futures that CapitalCom offers have a fixed -0.0011% interest on both short and long positions (assumption: this is their costs on offering this product and they are somehow required not to play with the interest rate on Futures).
However on the current spot price, the Long position has a +0.23% overnight fee and Short position has -0.25% overnight fee. That is, if I take a long position, I get a 0.23% PAID by the broker. Given that I’m using 10:1 leverage, this mean I get 2.3% on my equity, daily, because I use the broker’s money.
(This would indicate I could gain 69% in a month, which looks crazy. If I assume CapitalCom is shady, this is only justifiable if CapitalCom expects Natural Gas prices to fall about 6.9% in a month which would calculate 69% loss using the leverage, so they would get even on me),

I have a long position on the Spot and I have an equivalent short position on the NGF2025 to hedge huge movements in the price. As there was a small difference between the prices when I entered the trade, that is magnified by my position size, currently 200 (I’m testing with this).

I’m interested in collecting the overnight fee until the Futures expire. After that if the spot price is close to the next futures, I’ll just hop onto the next future contract, if they are far away then I close both positions (realizing the loss on one, and realizing the gain on the other, hopefully very close to each other).

Unfortunately, CapitalCom does not have historical overnight fees and they were not open to provide one, so they could play with this anytime, even 1 minute before market close. So I have an automated script that queries the overnight fee for Natural Gas and sends it to me on Discord so I can intervene if they quickly change that amount.

If they reverse the overnight fee and they pay for short positions, while spot price is still lower than futures, this requires more calculation as there will be a guaranteed loss when the two prices converge to each other.

#15

So I ended up abandoning this as the way spot prices and futures work with my broker IG are not what happens with actual futures.

IG also offer 2 futures for most and the spot price gradually makes it’s way from the front future to the back future until the front future expires.

The overnight credit would be balanced out by the movement in the spot to the 2nd contract.

Eg, say they offer Jan and Feb futures and there was 10 days left on the Jan contract
Jan 3000
Spot 3200
Feb 3300

Assuming no movement at all, the next day spot would be 3210, then 3220, 3230 and so on each overnight period a credit would be made to make up for the shift in the spot price.

Unfortunately I wasn’t able to find a way to reliably profit from this as any money made in credits were offset by the inverse movement in the spot price. Unless the future spot pair I was trading had a volatility spike that affected my trade favourably it wasn’t a viable option.

Have you found a way to trade it reliably?

#16

I’ll wait for 26th of December when the NGF2025 expires and will come back with exact numbers (open, close prices, overnight fees collected/paid). I have not yest tested what happens if I let the contract auto-expire at 20:30 CET.