When traders and investors talk about the price of a commodity like crude oil, gold, wheat or a nation’s currency, they tend to make the distinction between spot prices and futures prices. These reflect different but related aspects of the market for the asset in question.
What is a spot price?
The spot price is the current market price to buy or sell something for immediate delivery. Spot prices are in constant flux, mainly dependent on supply and demand of the asset at a particular time and place. The global nature of commodity and currency markets means that these spot prices are typically similar in different regions after accounting for currency exchange rates.
By contrast, a futures contract price is a predetermined amount to be paid for the item to be delivered down the line. The buyer and seller enter into a legal agreement for future delivery of the asset.
Here’s how this works in practice: A wholesale buyer of barrels of crude oil can decide to purchase at the spot price and expect to receive the delivery of the oil immediately. Or, they can agree with the seller on a price and accept delivery at some future date, using the futures price. For example, if crude oil is selling for $70 a barrel on a given day and a buyer wants the barrels right away, they would pay the $70 spot price. Another buyer who doesn’t need the oil for a while might make a deal with the seller for $65 a barrel, signing a futures price contract for delivery in six months.
Note that while spot and futures prices also can refer to the price of a security, these terms are most often used when talking about a commodity or currency.
How spot prices and futures prices are determined
Though the spot price and futures price of an asset can be different (especially when the futures contract is for a delivery far into the future), they are correlated. For example: High present-day demand for a product increases the spot price. So some buyers delay their purchases and opt for the futures markets if those prices are lower—and if demand in turn becomes high for future deliveries—the spot price tends to decline.
The biggest factor determining futures prices tends to be the spot price. But it also reflects an ever-changing mix of factors that include supply and demand, geopolitical events, and storage costs that increase with more distant delivery dates. Futures contracts can expire in different months, and even into the next year or several years in the future. Some assets have set expiration schedules, like Treasury bond futures. In many cases, futures are settled for cash rather than physical delivery, based on the difference between futures price and the spot price.
For the buyers and sellers, futures prices can serve as a hedge to protect against adverse price changes. A corn farmer who suspects prices will be lower in six months when the crop is ready to be harvested might want to lock in a price with a futures contract, for example. On the other side of the deal, a buyer who thinks that corn will be higher in six months will try to lock in current prices for the time of physical delivery.
The difference between spot prices and futures contracts are key in these decisions for buyers and sellers. When the spot price is lower than the futures price, that means the market expects the price of the commodity to rise in the future, and it’s referred to as being in “contango.”
In the opposite situation, when the futures price is lower than the spot price, investors expect the price to decline in the future. This is called “backwardation.” As futures contracts get closer to expiring, meaning the previously planned delivery is due, the spot prices and futures prices usually converge.
Price changes and how investors can interpret them
Commodities and currencies markets can have periods of volatility and stability, depending on the item in question. Commodities are physical goods that typically have to be harvested or mined, transported, and delivered to the buyer—so a lot of factors can affect any or all parts of that process.
Droughts can dent wheat and corn crop yields. War can prevent tankers from picking up or delivering crude oil. Labor strikes may reduce production at gold and silver mines. Currencies, too, are subject to unpredictable factors like geopolitical insecurity, changes in monetary policy, and rising inflation.
That’s a lot to think about for investors. While futures prices serve as a hedge for the buyers and sellers involved in the deals, investors can choose to use them to speculate on whether spot prices will rise or fall down the line.
But in a volatile market, correctly predicting pricing changes is particularly challenging. Overnight, an overseas skirmish or a hurricane can send prices of oil, wheat, or other commodities into a tizzy. For this reason, individual investors who are interested in diversifying their portfolios with commodities tend to turn to mutual funds or exchange-traded funds (ETFs) that track a major commodities index, rather than investing in the commodities directly.
The bottom line
In the commodities and currencies markets, the cost of an asset is categorized into two main areas: spot prices and futures prices. A spot price is the market price of an asset for immediate delivery, and it’s largely based on supply and demand. Because commodities markets are global, prices are usually about the same everywhere. Futures prices are the amount paid for an asset to be delivered in the future, in which the buyer and seller enter into a legal agreement.
Spot and futures prices are related, and a spot price is a major determining factor in futures contracts. Also, when high demand pushes the spot price up, some buyers head to the futures market—and if enough demand moves to futures, the spot price tends to fall. Commodities and currencies markets can be unpredictable because unplanned events like geopolitical conflict and natural disasters can hugely change pricing. Individual investors who want exposure to these markets but with less volatility, tend to turn to a commodities or currencies index fund.