How Futures Auctions Work Part 2 (Price Movement Explained)
Welcome to Part 2 of our series on futures auctions. In our last post, we discussed market participants and trading psychology. Today, let’s examine how and why price moves. As in Part 1, the intent is to provide a high-level explanation of how futures markets operate; for more detailed discussions, be sure to follow our blog.
Before we get into things like price discovery, backwardation and cantango, we’d like to share an important guiding principle that drives both our desire to educate and inform traders and our native successes:
There are two types of futures traders – hedgers and speculators. Commodity futures hedgers seek to limit price risk for a commodity they either sell or purchase. For the purpose of this discussion, we’re going to limit our examination to those who have no interest in obtaining or selling an underlying commodity: the speculators.
Price discovery
Futures contract pricing is achieved through a process called discovery. Price discovery occurs as traders place buy or sell orders at or near a point they perceive as a fair value at that time. The National Futures Association provides this explanation of price discovery:
“Futures prices increase and decrease largely because of the myriad factors that influence buyers’ and sellers’ judgments about what a particular commodity will be worth at a given time in the future (anywhere from less than a month to more than two years).
As new supply and demand [for the underlying commodity] developments occur, and as new and more current information becomes available, these judgments are reassessed and the price of a particular futures contract may be bid upward or downward. The process of reassessment—of price discovery— is continuous.
Thus, in January, the price of a July futures contract would reflect the consensus of buyers’ and sellers’ opinions at that time as to what the value of a commodity or item will be when the contract expires in July.
On any given day, with the arrival of new or more accurate information, the price of the July futures contract might increase or decrease in response to changing expectations. As the term indicates, futures markets “discover”—or reflect—cash market prices. They do not set them.
Competitive price discovery is a major economic function— and, indeed, a major economic benefit—of futures trading. In summary, futures prices are an ever changing barometer of supply and demand and, in a dynamic market, the only certainty is that prices will change.”
We believe that in order to identify price discovery effectively, you’ve got to be able to see the activity occurring in the marketplace. In other words, you’ve got to view the order flow, the interaction between buyers and sellers. That flow can reveal the motivations in the market.
Motivations of each side
Participants in today’s futures markets include mortgage bankers, farmers, bond dealers, grain merchants, lending institutions and individual speculators. No matter what market you’re trading in, there is a primary intention among all participants. Simply put, they all want to make money. For those who buy a particular commodity such as gold, they’re looking to hedge against future price increases. Those who sell want to make money by reducing their risk of a price drop. And those who simply speculate on contract prices are looking to profit on price movement. However, there are distinct motivations that underpin that primary goal. Price movement occurs because buyers, sellers and speculators are driven by different motivations.
As you continue to gain a deeper knowledge of price movement, keep this market truth in mind: ONLY ACTIVE TRADERS CAN MOVE THE MARKET. Put another way, only buyers and sellers who are agreeing on price cause the market to move in one direction or another. Each participant is looking to move the price to a level that represents fair value to him or her.
Why price moves in a particular direction
Volume can be tricky to decipher. Algorithm trading and high-frequency trades executed over micro-seconds have an impact on trade volume throughout a session. Some traders may be on a stop run, where price is moved to hit limit orders that are waiting to be filled (what NinjaTrader users call resting on the DOM). As price moves to a specific point, traders who correctly predicted direction may look to take profits or reduce inventory. And, although we may now understand the underlying motive of speculators on the buy and sell side, we can’t actually know what traders are thinking at the time of a trade.
Price movement results from a series of pushes and pulls in a direction. Buyers look to acquire positions from sellers who feel the time is right to get out. Price acceptance is the point when that exchange takes place. Whether or not a trader accepts a price is dependent on where she thinks fair value in the future will be.
So there will be some traders who will accept a certain price point and others who will prefer to hold onto inventory until price moves in the anticipated direction. Price acceptance occurs through a process we call probe and rotation.
Probe and rotation
Trade volume flows into price levels. Whether buyers are pushing prices higher or sellers pushing them down, trades are executed in an orderly flow. Probe and rotation indicate the back-and-forth nature of that flow. Maybe there is news that moves the market in one direction; this is the market “probing” the next price level. The counter move in the opposite direction reflects a rotation back to previous price levels.
Volume point of control
The volume point of control (VPOC) is a level at which both buyers and sellers agree represents a fair price. The VPOC becomes an important indication of fair price as time passes; this is typically the level where the highest volume is traded and markets try to gravitate towards the VPOC. As such, the VPOC is considered the efficiency point of the auction process.
There are situations which occasionally occur in asset markets where a futures contract price is not in balance with the financial instrument or asset’s current spot price. These instances represent price movement that runs counter to traditional market expectations. These situations are called backwardation and cantango.
Backwardation and cantango
Specific market conditions in the futures market can lead to backwardation. Backwardation is present when contract prices for delivery in distant months are lower than the nearest delivery month. This scenario occurs if the market expects an immediate shortage of a certain asset, most notably in the oil markets.
Contango, on the other hand, refers to a situation where the forward spot price is below the current price; speculators are willing to pay more for a commodity at some point in the future than the actual expected price of the commodity. When a market is “in contango”, the delivery price of a particular futures contract has to converge downward to meet the futures price.
Price movement – though difficult to predict accurately 100% of the time – can be anticipated correctly many times, if you know how the market behaves and you know what to look for. Over the next several weeks and months, we hope to help you become more familiar (and comfortable) with predicting price movement.