Futures Term Structure

Term Structure - Definition

Term Structure of futures contracts refers to the price curve formed by the prices of futures contracts over various expiration months.

Term Structure - Introduction

Futures contracts are usually offered across multiple expiration months for each underlying asset. Futures contracts of different expiration months trade at a different price reflecting differing future price expectation of the underlying asset. These different prices come together to form what is known as a "Term Structure". The term structure of futures prices often reveals critical information about the supply and demand relationship of the underlying asset which can be critical for traders.

This tutorial shall explore deeper what futures term structure means, how it affects your futures trading and how it can be used to help you make better futures trading and spot trading decisions.

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What Exactly is Futures Term Structure?

Futures term structure is the prices of futures contracts on a single underlying asset over all available expiration months. This is usually plotted down as a graph like the one you see below of S&P500 E-mini Futures on 16 May 2011:

Term Structure of ES Futures
Term Structure of ES Futures

How To Interpret Futures Term Structure?

Futures term structure curve can come in a variety of shapes. As futures prices are future expected prices of the underlying asset, the shape of the term structure curve tells investors the supply and demand characteristic of the underlying asset and serves as a good investment guide for investing in the underlying asset as well as for trading its futures contracts.

Futures term structure curve generally comes in two forms; Normal and Inverted.

Inverted and Normal Term Structure

Normal and Inverted Term Structure is also known as "Normal Market" and "Inverted Market" in futures trading.

Normal Market

Futures Term Structures with futures prices rising with longer expiration forming a positive slope curve is known as a "Normal Market". This is the most common form of term structure for commodities futures as the rising futures prices indicate the higher price of storage of the commodity with longer delivery months. Such a term structure tells investors that there are no severe shortage in supply or demand for the product and can also reflect inflation expectation in the months to come. Normal markets can also result in de-leveraging of your futures position when you roll forward due to the higher price of the next month futures.

Read more about Normal Market.

Inverted Market

Futures Term Structures with futures prices dropping with longer expiration, forming a negative slope curve is known as an "Inverted Market". The S&P500 E-Mini Futures Term Structure curve above is an example of an inverted market curve. Inverted markets are most commonly found amongst financial futures (or Cash Settled Futures) such as the S&P500 E-mini futures because there are no physical commodities to be stored and delivered at a later date and holding the futures contracts incur a loss of potential interest. Such a loss would become larger and larger the longer the futures contracts are held which is why financial futures display inverted market characteristics in order to compensate such a loss. However, inverted markets can also occur in commodity futures for short periods of extreme supply and demand imbalance. In fact, there are even commodities that go seasonally between a normal market and inverted market and such behavior can be taken advantage of using futures spreads such as the Futures Butterfly Spread.

Read more about Inverted Market.

Interpreting the Angle Of Term Structure Curve

The angle of a futures term structure slope also tells investors when violent price changes are expected for the underlying asset in the coming future. In general, the steeper the slope of the term structure curve, no matter normal or inverted, the more volatility is expected in the coming months. Many futures term structures also display seasonal steepening or smoothing within the same normal or inverted market which can be taken advantage of using Futures Butterfly Spreads as well. Near term futures contracts also tend to move more than longer maturities. As such, most steepening or smoothing of the term structure curve seems to be "pivoted" on the longer maturities with the near term contracts making the most price changes.

What Causes Changes in Futures Term Structure?

Futures term structure change when futures prices change. Even though a term structure curve might steepen or smoothen due to changes in short term supply or demand, the overall term structure in terms of normal or inverted market would not tend to change unless there is a drastic change in the supply or demand fundamentals for the asset. Basically, futures term structures change due to changes in price outlook of the underlying asset and such changes in price outlook are a direct result of trading by futures traders themselves, reflecting a fair price for the underlying asset after all possibilities of arbitrage has been digested away by arbitrageurs.

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