Understanding How Commodities Are Traded
Is it possible that something can have two prices at once? When it comes to commodities, it can happen! If you’re interested in commodities trading and wondering why they are traded as futures and not spot prices—while trying to understand what these both mean—this article is for you. Keep reading to learn more about futures pricing, spot pricing, and how commodities are traded.
What Are Spot Prices?
According to Investopedia, a commodity’s spot price is the current cost of that particular commodity, for current purchase, payment, and delivery. In commodity spot contracts, payment is required immediately, as is delivery. The deal is done “on the spot”—hence, the name “spot price.”
In a more general sense, a commodity’s spot price represents the price at which the commodity is being traded at the current time in the marketplace. Traders and investors track the spot price of a commodity as they would stock prices. When people quote a commodity’s price, as in “gold is trading at $1,800 an ounce,” it’s the spot price they’re usually referring to.
What Are Futures Prices?
In the same Investopedia article, the futures price applies to a transaction involving the commodity that will occur at a later date—literally, in the future. A commodity futures buyer is locking in a price in advance, for an upcoming delivery.
A commodity’s futures price is based on its current spot price, plus the cost of carry during the interim before delivery. Cost of carry refers to the price of storage of the commodity, which includes interest and insurance as well as other incidental expenses.
Commodity futures prices can be calculated as follows: Add storage costs to the spot price of the commodity. Multiply the resulting value by Euler’s number (2.718281828…) raised to the risk-free interest rate multiplied by the time to maturity.
For example, assume the spot price of gold is $1,200 per ounce and it costs $5 per ounce to store the gold for six months. The six-month futures contract on gold, given a risk-free interest rate of 0.25%, is $1,206.51, or (($1,200+$5)*e^(0.0025*0.5)).
The prices of commodities futures are not always higher than spot prices. Futures prices take into account expectations of supply and demand and production levels, among other factors. The difference in a commodity’s spot price and the futures price at any given time is attributable to the cost of carry and interest rates.
How Commodities are Traded
Spot prices are what the commodity is worth today, right now, if you were to buy it for immediate delivery. Futures prices are the agreement between the buyer and the seller for what it will be worth on a future delivery date. Spot prices influence the futures price.
Supply and demand also influence what the futures price will be. Knowing the outlook and keeping track of current events and other important information relevant to the commodity will help you determine a futures price.
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