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Normal Market - Definition
In futures trading, normal market is when the prices of futures contracts on an asset becomes progressively more expensive with longer expiration months.
Normal Market - Introduction
A normal market in futures trading is when the futures contracts are more and more expensive as expiration becomes longer. Yes, in futures trading, the price of futures contracts can actually get cheaper and cheaper as expiration becomes longer. That is known as an "Inverted Market".
A normal market is the most common form of futures market condition and is the condition which you are most likely to run into in commodities futures trading. It is a market condition which underlies a normal market condition in which an asset becomes more expensive over time due to storage cost, hence the higher futures prices.
This tutorial shall explore in depth what normal market is in futures trading, how it occurs and how it affects your futures trading.
What Is a Normal Market?
Normal market is one of two possible term structures in the futures market, the other being the inverted market. Term structure refers to the way futures contracts across different months are priced, just like what term structure means in bonds trading.
The picture below contains the real futures chains on AAPL Single Stock Futures on 22 Sep 2010. Notice that prices are higher the further the expiration month becomes? From $284.77 for the October contracts to $287.92 for the March 2011 contracts.
When prices of futures contracts are progressively higher with longer expiration months, it is known to be in a normal market or having a normal term structure. It doesn't matter if the prices are generally higher than or lower than the spot price. As long as futures prices are progressively higher with longer expiration, it is known as a normal market. The diagram below shows three different possible forms of normal markets.
A lot of people refer to normal markets as contango markets and inverted markets as backwardation markets. It must be made clear that contango and backwardation has to do with the price behavior of near term contracts as expiration draws nearer. They are not terms to describe the term structure of futures contracts.
Effects of Normal Markets
In a normal market, futures contracts with longer expirations will be more expensive than futures contracts with nearer expiration. As such, when you roll forward futures contracts in a normal market, you would only be able to take position on a lesser number of contracts than the expiring ones due to the higher price of the further month contract or maintain the same number of contracts by adding more funds. Both of these lead to de-leveraging.
Normal markets in which prices are above spot price can also result in contango where the higher prices of far month futures contracts gradually converge downwards with the spot price over time, putting the odds in favor of the shorts.
What Causes Normal Markets?
Futures markets in which futures prices are progressively higher with longer expiration are considered "Normal" because theoretical futures price under the no-arbitrage principle is made up of the current spot price plus storage costs for holding the physical product and other forgone opportunity costs such as interest.
Such a condition exist when the market for the physical product is largely normal with no severe lack in supply or demand. Investors in the futures market to trade the underlying asset could either buy the physical asset and store it up until they are needed or get into a futures contract taking delivery when the physical assets are needed. Eventually, the costs incurred should be the same if futures prices are at theoretical levels.
Normal markets also exist due to inflation expectations or simply expectation of a lack of supply in the future in which the price of the underlying asset is expected to be higher. In this case, producers needing these commodities for production during those expected tight supply months would rush for futures contracts on those months, pushing futures prices of far month contracts to be way higher than theoretical values, opening up the possibility of futures arbitrage.
As normal markets and inverted markets are both a result of supply and demand, the term structure of some commodities tend to be seasonal as well. There are commodities that juggle between normal market and inverted markets based on their seasonal trends.
Normal Markets in Contango and Backwardation
Normal markets can happen in both a contango market or a backwardation market. However, normal markets are most commonly associated with contango markets as normal markets in backwardation is extremely rare.
Normal markets in contango has progressively higher futures prices and the near term futures price higher than spot price. Single Stock Futures on the AAPL is currently in such a condition on 24 Sep 2010. In such a market condition, the prices of all of the futures contracts of that particular asset converge downwards towards the spot price over time. Such a market condition is perfect for futures arbitrage by taking positions in the physical asset and then going short on the overpriced futures contracts when futures prices far exceeds the cost of carrying the physical asset itself. Such a condition is also known as "Super Contango" in order to differentiate it from the normal contango markets where the progressively higher futures prices reflect progressively higher cost of storage with longer expiration. Contango markets are also conducive for going short as rolling forward results in a positive roll yield (as you will be shorting at progressively higher prices with each passing month) as long as the normal contango lasts.