impact of market structure on differential trading
DESCRIPTION
A brief illustration of how differential or basis trading is impacted by an inverted futures market (in which the distant months trade at a discount to the front months)TRANSCRIPT
Differential TradingNormal vs. Inverted Markets
David JoelsoniRely LLCJanuary, 2011
Purpose: To Explain the Impact of Market Structure on Differential Price Quotes
Traders and customers have become used to a fixed differential (or basis) quote covering multiple time periods
For example, a trader will typically offer product for delivery each month, June through December, at the same differential price such as $.20/Lb over the relevant futures market
However, this practice only works in a normal futures market when the nearby month is lower than the distant month
When markets are inverted (nearby month higher than distant month), the differential quote will vary by month
The purpose of this presentation is to explain why this is so.
Normal Market Example Cost of product on May 1 is $2.00/Lb
May Futures = $1.80Therefore, differential = May + 20 for May Delivery
On May 1, July – Dec futures trade atJuly $1.82
Sep $1.84
Dec $1.87
Assume that the cost to store product = $.01/Lb./month
Therefore, if the trader holds the product until December:Cost to trader is $2.00 plus 7 months carry @ 1 Cent/month = $2.07
Dec trades at $1.87
Therefore, differential for December delivery is + 20…exactly the same as it was if delivered in May!
Graphic Illustration of Normal Market
Cost increases at a rate of 1 cent/month
Futures market ‘steps up’ over time at about the same rate as cost of carry
Differential each month is tight around the average of about 19.4 cents
Differential
Inverted Market Example Cost of product on May 1 is $2.00/Lb
May Futures = $1.80Therefore, differential = May + 20 for May Delivery
On May 1, July – Dec futures trade atJuly $1.78
Sep $1.76
Dec $1.73
Assume that the cost to store product = $.01/Lb./month
Therefore, if the trader holds the product until December:Cost to trader is $2.00 plus 7 months carry @ 1 Cent/month = $2.07
Dec trades at $1.73
Therefore, differential for December delivery is + 34 …significantly higher than if it was delivered in May
Graphic Illustration of Inverted Market
Cost increases at a rate of 1 cent/month
Inverted Futures market is lower in distant months reflecting tight supplies today
Differential each month steadily increases from + 20 cents spot to +34 at year end. Average is more than + 26 cents
Differential