Introduction

In this chapter, we will explore the differences between normal and inverted futures markets. Futures markets can take on different shapes depending on the relationship between the futures contract prices and the spot prices of the underlying asset. Understanding these market structures is crucial for traders and investors to make informed decisions in the derivatives market. Let’s delve into the concept of normal and inverted markets and their implications.

Normal Futures Market

A normal futures market exists when the futures contract prices are higher than the spot prices of the underlying asset. In other words, the futures contract trades at a premium compared to the current market price. This situation typically occurs in markets where the demand for the underlying asset is expected to increase in the future. Investors and traders are willing to pay a premium to secure the asset at a fixed price through a futures contract.

Example: Consider the crude oil futures market, where the current spot price of crude oil is $70 per barrel, but the one-month futures contract is trading at $72 per barrel. This indicates a normal market, as investors expect higher demand or potential supply constraints in the future, leading to a premium on the futures contract price.

Inverted Futures Market

An inverted futures market is the opposite of a normal market. In this scenario, the futures contract prices are lower than the spot prices of the underlying asset. The futures contract trades at a discount to the current market price. Inverted markets usually occur when there are concerns about the future demand or supply of the underlying asset, leading investors to sell futures contracts at a lower price to avoid potential losses.

Example: In the wheat futures market, suppose the current spot price for wheat is $500 per ton, but the three-month futures contract is trading at $480 per ton. This suggests an inverted market, indicating that traders are willing to sell futures contracts at a discount, possibly due to expectations of a surplus in the future or declining demand for wheat.

Implications of Normal and Inverted Markets

The presence of normal or inverted futures markets can have several implications for traders and market participants:

• Trading Strategies: Traders can use the knowledge of market structure to formulate appropriate trading strategies. In a normal market, they might consider going long on futures contracts to capitalize on potential price increases. In an inverted market, short positions may be preferred to benefit from expected price declines.

• Market Sentiment: The market structure reflects the collective sentiment of market participants regarding the future prospects of the underlying asset. It can provide insights into the overall market sentiment.

• Arbitrage Opportunities: Normal and inverted markets may create arbitrage opportunities for astute traders. Arbitrageurs can take advantage of price discrepancies between the spot and futures markets to make risk-free profits.