Rolling Cash Commodities vs Futures, Who Wins?

Simoh

Junior member
There have been claims in this forum recently that (commodities) cash bets are cheaper and more transparent than futures bets, and that they are good for the client. Here I will try to explain why I think this is not the case, that in fact they are less transparent, not more, and that for many spread bettors they are more expensive, not less.

First some background:

When a consumer wants to buy the product at a future date, he must agree a price with the producer to pay on that date, and obviously that price needs to be fair to both parties otherwise the deal wouldn't happen.

A futures price is determined by the spot price with some extra factors thrown in.

Firstly, you can't buy anything tomorrow at todays price; I'd like to buy my house for the 1980 price, but unfortunately that's not possible. The only fair future price is todays price plus the interest that is lost by not having had the cash from the day the deal was done, but having to wait for it until the future date. This is the financing cost. So (some of) the difference between the spot price and the futures price is this, and futures contracts typically use a very low rate to establish this price adjustment, the kind of rate you could get in the money markets (say LIBOR) rather than the rate a bank would charge you.

This doesn't account for all of the price differential though. What you are agreeing to buy in the future may need storing and insuring, it may confer some value on the holder in the meantime, so all these factors, and usually more, have to be taken into account when the price is agreed. This is the beauty of the market though, a fair price to both parties is discovered by it.

So, why would some SB firms rather not let you bet on a futures price, but de-construct it into a notional cash price? Like anything, it boils down to revenue. Banks and financial institutions love a commission, and they are getting more inventive with how they extract them in increasing sizes! Look at charges for funds, or even the causes of the economic crisis as evidence.

If the futures price is de-constructed into it's component parts (notional cash price + financing + other stuff) it means the SB firm can get more commission. The financing rate will be received by the SB firm, rather than being contained within the price of the futures contract where they can't get at it, and even better, the financing rate can then be increased too, say LIBOR + 2 or 3%!

What about the rest of the difference between the two prices, the other stuff? Well, this is where it gets tricky, because the de-construction formula isn't published, or explained in a clear manner. This isn't necessarily surprising because it'll be fairly complex and hard to follow, but what it does mean is, you can't work out whether it's fair or not, you just have to trust the firm! In all likelyhood it will be a similar story to the financing, it will repesent the market value of the other stuff, but the firm will take an additional cut.

So, we KNOW the financing is more expensive for a notional cash bet, and we suspect that more is being charged for the other stuff, so it's definitely more expensive to hold a notional cash bet than it is to hold a futures bet, by at a reasonable guess, say 5%.

We don't know the de-constructing formula the firm is using, but we know the futures market is a fair price, so therefore the notional cash bet is LESS transparent, not more transparent than a futures bet.

Essentially, if you don't hold the bet overnight then you won't pay these charges, all you pay is the spread. If you are a day trader then, it boils down to which spread is tighter, the notional cash, or the future. This will almost certainly be the notional cash bet, so day traders benefit here.

If you are not a day trader it gets more complicated. Again, because we don't know how the notional is constructed it becomes difficult to work out, especially for long term bets.

I'll try to explain with an example; unfortunately more jargon is required. The futures price is spot price + financing adjustment + other stuff. This all adds up to a futures price that can be above or below the spot price. If the futures price is above the spot it's said to be in 'contango', if the futures price is below spot it's termed 'backwardation'. So what? Well, at the date the future expires it's price has to be the same as the spot price, otherwise someone would get a free lunch by buying one and selling the other and pocketing the difference.

This means a futures contract in contango will gradually fall in price as time goes on (the reverse for backwardation).

Say you want to bet oil will be higher in one month. You have a choice of 2 contracts, april at $100 or may at $110 (spot price is say $98). If you buy the may contract you can expect it's value to fall more over time than the april contract, and, if you are betting on a price rise, a contract with a falling price is bad! You would almost certainly pick the April contract for this bet.

If you take a notional cash bet however, the SB firm don't know how long you plan to keep it open. Once you keep it open overnight they have to charge you something, but how much? They are going to have to charge you one days worth of financing, plus a few percent, and one days worth of 'other stuff' too (possibly plus a few percent again). Which contract are they going to break down? Will they look at the contract with the biggest contango, i.e. the biggest 'other stuff' and charge you a fraction of that? That would make sense as a good insurance policy in case everyone holds bets that need hedging there. Will they use statistical analysis on bettors habits to come up with a formula that uses fractions of different contracts 'other stuff' that represents the likely distribution of customer's bet holding periods? Possibly.

It would make the most sense though to use the most expensive contracts because it's the least risk for them. And there's another advantage. If they didn't, and someone worked out their secret formula, they might be able to take advantage of it.

What it all means then is if you hold your position for one night or longer you pay more than you would on a futures bet. You pay more financing, you pay a more expensive slice of the 'other stuff', and possibly a premium on that too. And your costs are opaque, NOT transparent.

So, in summary, notionals are probably good for day traders (check your spreads), but a nightmare for position traders, even if you're planning to hold for the occasional night. When you consider that a lot of time, effort and participants in the futures markets have gone to make up the fairest possible price, why would you want to use a different one?
 
Last edited:

lancenicolase

Active member
That's the point I and other traders tried to make on CMC thread.
Cash oil is less transparent and only good for spread betting company.
 
 
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