A futures contract is a forecast of what market participants project the prices of the products to be in the future at contract expiration. This price is known as the cash price which represents the current value of the underlying product. Understanding the relationship between the cash price and the futures contract front months can help traders form trading ideas to help guide their strategies.
Why the Front Month Matters
Traders tend to follow volume to ensure there is enough volatility to present trade opportunities and liquidity for their orders to be filled. The highest volume front months are generally tied to a related event for the underlying product.
Every futures contract is equipped with a product symbol, expiration month (also known as front month) and the last two digits of the expiry year. Some futures contracts expire on a monthly basis while others expire every few months.
As an example, ZW 05-17 is the CME Wheat Futures contract for May of 2017. Once the ZW 05-17 expires, active Wheat traders will roll open positions to the successive contract, ZW 07-17.
As the front month nears expiration, the price of the futures tends to gravitate closer to the price of the underlying products at physical delivery. Factors that could potentially impact cost at delivery are known as the carrying cost and can include:
Compare Cash Prices to Futures Contracts
When comparing cash prices to futures contracts, there are two types of market dynamics that can impact pricing: normal markets & inverse markets.
Also known as a premium market, the prices at nearby front months tend to be lower and further front months are at a higher price. This price increase may be driven by the carrying costs. Additionally, cash prices may be lower due to an oversupply of the product.
Also knows as discount markets, prices at the nearby month tend to be the highest and further front months are at lower prices. An inverted market could indicate that there is a shortage of the cash product where users of the product may need to purchase whatever is available causing the cash price to be higher than future prices. For example, if the Wheat in a region has not been harvested, supply is expected to be low before the year’s harvest.
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