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futures-convergence to the physical market?
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futures-convergence to the physical market?

  #1 (permalink)
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futures-convergence to the physical market?

I am studying an online technical analysis course and the professor brings up an interesting point that I am trying to understand. Apparently, in Gold or Silver, for example the amount of open interest can far exceed the actual physical supply. However, I was looking on the NYMEX page about WTI crude oil and they state: that WTI has convergence to the physical market. Does this mean that that physical supply has to at least equal the open interest? And I am trying to find information on Investopedia and found this

DEFINITION of 'Spot Market'

1. A commodities or securities market in which goods are sold for cash and delivered immediately. Contracts bought and sold on these markets are immediately effective.

Now, what exactly does a spot market mean? Does the amount of physical commodity have to match the available supply of the commodity.

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The WTI contract on NYMEX is a deliverable contract.

This means that if you go long 1 futures contract and do nothing until expiry, you will get delivered the physical oil.

The place where the oil will be delivered is the pipeline depot in Cushing Oklahoma.

If you go short 1 futures contract and do nothing until the contract expires, you will have the obligation to deliver the physical oil in Cushing, Oklahoma.


Now imagine that the contract price for the futures contract is not converging to the price of the physical oil at expiry. Let us assume that the price of the futures contract has been pushed up by speculators and is significantly higher than the price of physical oil.

In that case a physical oil trader can make a significant profit, if he decides

-> to buy cheap physical oil in Cushing
-> sell short a futures contract at a much higher price

The oil trader will then wait until expiry of the futures contract and deliver physical oil that he as purchased.

The conclusion is that arbitrage opportunities between physical oil and paper oil will make prices converge. Of course this is only true, if enough market participants have access to the physical oil. Market access is particularly difficult in Cushing, as you cannot purchase a cargo of crude and then bring it there. You really need to catch some truck loads of shale oil or the pipeline stuff. The fact that Cushing, Oklahoma was chosen as destination for the delivery of the crude, makes the contracts easier to manipulate. In fact this choice was responsible for the Cushing Contango - a permanent contango situation that did not affect other contracts such as the Brent Crude traded at IPE (ICE).

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Above is technically true, but impractical in actuality. Majority of the brokers will forcibly terminate your position prior to any physical delivery unless you specifically tell the broker otherwise.

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Big Mike View Post
Above is technically true, but impractical in actuality. Majority of the brokers will forcibly terminate your position prior to any physical delivery unless you specifically tell the broker otherwise.

Sent from my phone

A paper trader - that is 99.9% of all traders here - will not be allowed to open physical positions. In my post I had also explained that arbitrage can be done by physical oil traders, because those also have access to the spot market.

That said I have not answered the original question of @e4williams, who asked what a spot market means.


The spot market means the physical market for oil. A spot contract is the purchase and sale of physical oil which is stored somewhere in a depot or a cargo. The purchase has to be fully paid for and the purchase will have to pay storage fees and use or resell the crude oil.

The futures market is a paper market, where a position is entered on margin. Daily gains or losses are credited or debited to the account based on the daily settlement price.

A paper position can be converted to a physical position and vice-versa. This is called exchange for physical (EFP).
This method basically allows to lock in a price for physical supply prior to purchasing the physical oil. The purchaser of the physical oil sells the paper position and acquires the physical position (basically a swap).

https://www.theice.com/publicdocs/IPE_EF_Explained.pdf

Such swaps and the possibility of arbitrage (only possible for physical oil traders) make sure that the price converges when expiry of the contract approaches. By the way this is the reason that all futures contracts must have an expiry date. Otherwise there would be no convergence.

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Regarding open interest on futures

I do appreciate the response,
However, You still haven't answered the underlying question that I am asking.

There appears to be two different types of markets with futures.

One market where the actual physical amount of the commodity must match the open interest contracts.

And another market in futures, where the open interest can far exceed the physical availability of the commodity. For example with Gold and Silver.

So, I guessing a spot market means if you take that contract to expiration, you bought that quantity of the commodity and must pay cash for that and accept delivery. Now in a spot market must the amount of open interest contracts match the actual amount of the commodity?

Historically speaking ( I know they have been inventing new derivatives for years now.) When did first the futures market deviate from being able to sell more open interest than the actual physical availability of the commodity. Apparently, someone along the line figured out that most people were just trading the market with no expectation of actually buying the commodity so just lets boost the amount of the open interest. And open up that market venue.

Now what would happen in the Gold or Silver futures market where the amount of contract brought to expiration where the buyer is expecting delivery exceeds the amount of physical commodity? Well. the derivatives designers of such have probably studied the averages and statistics of such so that won't happen.

As a novice to the futures market. something smells here. I just became aware of this recently, taking an online technical analysis course where the professor identified this deviation.

Perhaps I don't understand this well enough, Clue me in if I am wrong. Someone along the line figured out how to make an extra buck selling more commodity that is what is actually available. What is what futures I would think should be about.
No?

Something really smells fishy here, just entering this field and I am very good at smelling fishy.

If someone can explain to me my question in simple terms where I can understand, I would appreciate that.

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e4williams View Post

There appears to be two different types of markets with futures.

This is misunderstanding. Cash (or what you call spot) oil markets arenít futures markets. They are predominantly OTC markets where mostly large participants make transactions of physical commodity with immediate delivery. That is the definition. There are many grades and points of delivery for crude in the US where cash prices for physical crude vary. Even for WTI (e.g. WTI Cush, WTI Midland etc). Data from those markets in some cases never become available for broad public. Re WTI, generally speaking, what you trade on NYMEX in form of CL is a future contract. Hope it helps.

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  #8 (permalink)
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e4williams View Post
I am studying an online technical analysis course and the professor brings up an interesting point that I am trying to understand. Apparently, in Gold or Silver, for example the amount of open interest can far exceed the actual physical supply. However, I was looking on the NYMEX page about WTI crude oil and they state: that WTI has convergence to the physical market. Does this mean that that physical supply has to at least equal the open interest? And I am trying to find information on Investopedia and found this

DEFINITION of 'Spot Market'

1. A commodities or securities market in which goods are sold for cash and delivered immediately. Contracts bought and sold on these markets are immediately effective.

Now, what exactly does a spot market mean? Does the amount of physical commodity have to match the available supply of the commodity.




e4williams View Post
I do appreciate the response,
However, You still haven't answered the underlying question that I am asking.

There appears to be two different types of markets with futures.

One market where the actual physical amount of the commodity must match the open interest contracts.

And another market in futures, where the open interest can far exceed the physical availability of the commodity. For example with Gold and Silver.

So, I guessing a spot market means if you take that contract to expiration, you bought that quantity of the commodity and must pay cash for that and accept delivery. Now in a spot market must the amount of open interest contracts match the actual amount of the commodity?

Historically speaking ( I know they have been inventing new derivatives for years now.) When did first the futures market deviate from being able to sell more open interest than the actual physical availability of the commodity. Apparently, someone along the line figured out that most people were just trading the market with no expectation of actually buying the commodity so just lets boost the amount of the open interest. And open up that market venue.

Now what would happen in the Gold or Silver futures market where the amount of contract brought to expiration where the buyer is expecting delivery exceeds the amount of physical commodity? Well. the derivatives designers of such have probably studied the averages and statistics of such so that won't happen.

As a novice to the futures market. something smells here. I just became aware of this recently, taking an online technical analysis course where the professor identified this deviation.

Perhaps I don't understand this well enough, Clue me in if I am wrong. Someone along the line figured out how to make an extra buck selling more commodity that is what is actually available. What is what futures I would think should be about.
No?

Something really smells fishy here, just entering this field and I am very good at smelling fishy.

If someone can explain to me my question in simple terms where I can understand, I would appreciate that.

"Spot" means the actual physical market. If you go and buy the physical commodity and take it, you are trading on the spot market. The spot market is not a futures market. And yes, you can only buy as much as is physically available.

There is a spot market in everything. Gold and silver too. You show up with some cash at a dealer, put it on the counter and take some gold home. (You won't be getting the best possible price if you buy retail, of course.... the actual "spot" price will be the price it is bought and sold for in the larger wholesale physical market, but there is always a market of cash for the actual commodity, delivered now, no matter what the commodity is.)

So that's one point: spot is physical stuff bought and sold now for cash. Also called the "cash" market. It's not on a futures exchange; it's not any kind of futures market.

Next point: is it fishy that there are more open contracts on a futures market than there will ever actually be physical commodities delivered and paid for?

You need to understand why there is a futures market in the first place. It's so that suppliers and buyers of commodities can hedge their market risk when there is future delivery. What does that mean? If the price changes significantly between now and, let's say, the time a farmer harvests his crop and is ready to deliver it, he may have either a welcome windfall profit if it went up, or a big loss if it went down.

He can eliminate that market risk by taking a short (sell) position in the futures market. If the price of his actual physical harvest goes down, his short position will go up by the same amount and he will be insulated from the market change. But if the price goes up, his loss on the short will offset the better price on his actual harvest. He comes out even either way. There is no actual net profit or net loss due to market price changes, because his physical crop is completely hedged.

It works the same way, but inversely, for the actual buyer of the commodity, the one who will actually take delivery. He will want to be long the futures. If the price is higher at settlement, which would normally be a negative for him, he has an offsetting profit on the long position of the same amount. If price went down, which normally would be good for him as a buyer, he has an offsetting loss on his long futures -- he is insulated from having to pay higher (net) prices if it goes up, but gives up the benefit of lower prices if it goes down. So he is also hedged -- meaning, his/her eventual net cost is locked in and is not subject to the market, just as the producer's is also locked in.

Traders who are not hedged take up the middle ground between the eventual producers and the eventual buyers. They may be the buyers of the futures contract when the farmer sells it, or the seller of the contract when the eventual commercial buyer buys it. Generally they are doing this without being hedged, so they do not have the offsetting change in the value of, say, a wheat crop in the ground, so they can, and will, have a net profit or loss. Their motivation is of course the opportunity for profit, and that opportunity exists because they have taken on the market risk that the hedgers have unloaded to them.

Eventually, they are going to have to close out their positions, at a net profit or loss, before having to actually make or take physical delivery. But at any one moment in time, up until settlement, there will be more contracts in existence than will eventually be settled with a delivery. It is not that anyone is somehow selling something that does not exist; non-hedged traders are taking on market risk that hedgers want to unload, and eventually the non-hedged traders will have to close their positions and take their net profits or losses.

This is a long response. I hope it is at least somewhat understandable. If it's not, I apologize, but you will need to understand the nature and the economic reason for futures markets (hedging market risk) before you can answer the questions you asked. I would also say, before you study the technical analysis of futures markets. Or trade them.... because if you are trading futures, you are probably going to be one of those un-hedged traders seeking to make a profit, so you should know what you are actually trading in....

If this has not answered your questions, I suggest spending some time on Wikipedia and/or Google, until you understand better what the futures markets are all about. Like everything else, it's complicated when you first get into it, but it's actually simple when you understand it.

I hope this has been of some help, anyway. Good luck with your studies of it.

Bob.


Last edited by bobwest; January 4th, 2015 at 11:59 AM.
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open interest

Thank you for your answer to my question.

Just a quick reply to your answer. It's probably going to take me three days or longer to understand this. Give me time.

Again, thank you for your time in answering my question so thoroughly. At the age of 55, probably the second best answer to a question that I ever asked. Coming from an English/Biology educational background. I was taking a microbiology course at the University of Pennsylvania and the professor was on viruses. Having a prior cell biology
course, I know that the energy provided to a cell is by the breakdown of ATP to ADP Adenosine Tri Phosphate to Adenosine Mono Phosphate. Apparently to the loss of two phosphates provides this energy. The virus lands on a cell and injects RNA into the cell which takes over the DNA mechanism. So, I asked the professor without the ATP that provides the energy to the cell how does the virus inject the RNA into the cell? He said it was done by mechanical means. Actually, thinking back on this. This was not much of an answer. Viruses are interesting, the question is are they living or are they non-living. Biology is actually more interesting to study than oil but, hey, you gotta make a buck.

As really new to most of this: Though I have traded options since on 98',
Have also making a good news study on the oil market. After a day and a half of study, I have seen what seems to be brought down to really a few basic facts. The Saudis, with OPEC. I don't know if the Saudi's run OPEC or not, have decided not to cut production. Primarily, because U.S. production of fracking oil is significantly increasing supply. The Saudi's have capital reserves, they can wait. The drillers fracking are relying on Junk Bonds to finance their operations, the fracking wells are good for three to seven years, after three years their output significantly dries up, they have to show a profit, so they drill more wells. The Russians, having 30% or more of their GDP dependent on oil, have no choice but to continue to sell their oil. Seems like the Saudis have taken it upon themselves to try and control the price of oil. the Chinese reliance upon oil is growing.

My call on the price of oil, is that it's going to take a quick spike after several more weeks down to around 33 and then make a nice bounce back to about 45 or so.

Well, after two tulip bulbs, and a couple of Ponzi's. Here we are.

Well, again, to make a buck, it probably makes a lot of sense to understand the dynamic behind the market. This is much more of a player's market than the market back to 60's or 70's when the market was based on the performance of company and when the PE ratio should be around 10.

As a quick question, how did George Soros, make his two billion? Shorting a currency. How does shorting a currency or a stock for that matter negatively affect a company?

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e4williams View Post
As a quick question, how did George Soros, make his two billion? Shorting a currency. How does shorting a currency or a stock for that matter negatively affect a company?

No idea, not my field.

On another note, I'm glad that the answer I gave to your questions made at least some sense to you. It's just about the basics of the markets; how to trade them is another matter. But it's good to get these issues cleared up....

Bob.

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