Other Considerations of Price Relationships

The floor price or base level a near term future may trade relative to a farterm future can be applied to most markets. However, this relationship is different with some markets like the meats, because they are perishable, or cannot be stored easily like coffee or stocks. A hog comes to market and must normally be sold within a definite period of time. The futures contract for one month may move independently of another month because the cost of carry calculations do not readily apply. The arbitrageur may not be able to buy the near month, as in the coffee example, and inventory the commodity because it is not easily stored.

Some futures markets do not have the same types of relationships between different contract months. Many of the financial and precious metal markets do not have the same type of supply and demand problems. If the stock market rallies or drops, the near-term future should rise or drop the same amount as the further out months. The difference in prices between months are invariably determined by the carrying costs from one month to another. There is not much difference between a September S&P5OO future and a December S&P5OO future.

One other point to consider: Although spreads should never theoretically be above or below a certain level, there can always be unusual market conditions where this could actually occur. For example, July coffee might sell off sharply but the September contract might decline a lesser amount due to price limits. The July future could be much lower than the September future price, even though the theoretical price should be higher.

Another reason the spread could go beyond carry is that arbitrageurs may not be able to put on any larger position size due to margin or other reasons. Some markets may not be easily arbitraged, or some moves may be so great, the arbitrageurs may not have enough buying or selling power to overcome the discrepancies.

You might be comforted in knowing the spread should eventually get back to proper theoretical levels once the market gets back to "normal." However, your brokerage firm might take a distinctively different viewpoint and send a margin call. There is little comfort in thinking you are right but having to liquidate a position anyway. Markets may sometimes take much longer than anticipated to get back to "normal."