Both futures and forwards offer a mechanism to manage risk and investment exposure in the commodity markets.  The structure of these two types of markets is subtly different, and these differences can have implications for the relative cost of trading and investing in these products.  This paper examines the implications for the cost of trading in the markets for futures and forwards in metals using the aluminium market as the example case.

Futures Markets

Both futures and forwards represent an investment for the future delivery of metal.  One of the main structural differences between futures and forwards is the form of the expiry dates that are made available.  Futures are made available in contract months.  There is usually one month that is more actively traded at any point in time.  Whilst delivery of metal is the bedrock of both futures and forwards, it’s more common for positions to be closed out ahead of delivery or rolled forward to a further dated contract.  Market liquidity is therefore important to an investor both when the position is opened and when it is closed out.  This liquidity manifests itself in the bid-offer spread, which is paid by the investor.  In the case of futures, where a position is opened in the active contract month, which has the most liquidity, when this is closed out say a month later, this contract month is still likely to be the most active contract month, therefore offering high levels of liquidity for the closing transaction.

To put some numbers on this, let’s take as an example a transaction for a $1 million investment exposure in Aluminium futures at COMEX.  With the contract price at $2,788 per metric ton, and a contract size of 25 metric tons, this implies a purchase of 14 futures lots.  The observed bid-offer spread on the active month futures contract is three ticks, or $1.50 per metric ton, which equates to $37.50 per lot.  Assuming that position is still in the active month when it’s closed, the investor would face the same bid-offer spread.  Therefore, for the trade as a whole, the cost of the bid-offer spread can be calculated as $525 for the $1 million exposure.

The bid-offer spread for futures months other than the active month is typically five ticks, or $2.50 per metric ton.  If, by the time the position was closed, the position was no longer in the active month, the investor would face a wider bid-offer spread on the closure.  In this case, the cost of the bid-offer spread for the trade would be the average of $1.50 and $2.50 per metric ton, or $700 in total.

Exchange fees are another cost of trading that can be examined, although these can be relatively small when compared to other costs such as the bid-offer spread, brokerage charges, etc.

For futures trading, the fee structure can be straight forward.  The non-member transaction fee for a screen-based transaction is $2.50 per lot, for both opening and closing the position.  For the $1 million trade as a whole, this is therefore $70.  The combined cost from bid-offer spread and exchange fees is therefore $770 for this transaction when executed as futures.

Futures Transaction

           
               

Opening Trade-Active month

           
     

bid

offer

spread

 

Non-member fee per lot

Buy

14 lots

July-22 ALI

$2786.50

$2788

$1.50

 

$2.50

               

Closing Trade-Non active month

           
               

Sell

14 lots

July-22 ALI

$2768

$2770.50

$2.50

 

$2.50

               

Spread Cost

Average spread x Number Lots x Lot Size

   
 

=

((1.5+2.5)/2) x 14 x 25

     
 

=

$700.00

         
               

Fee Cost

 

Fee per lot x Number Lots

     
 

=

(2.50 x 14) + (2.50 x 14)

       
 

=

$70.00

         
               

Combined Cost

$770.00

         

Source: Bloomberg LP.  See Footnote 1

Forwards Markets

In contrast to futures, forwards markets are made available with daily contracts.  The greatest liquidity is available in the date that is three months forward from the trade date.  This provides a convenient entry point for opening a position, but once the position is held for more than a day, the market liquidity shifts to the next three-month date, and liquidity for the date of the open position is considerably worse.

There are trading strategies that are used to manage this liquidity risk.  Expiry dates (often referred to as prompt dates) on the third Wednesday of the month are quoted further out, and these provide a slightly better location to hold open interest.  The bid-offer liquidity in these dates is still poor compared to the three-month date, but better than a completely off-cycle value date.  As examples of bid-offer spreads quoted on screen, the active three-month date for aluminium will typically see a spread of $1.50 per metric ton, whereas the bid-offer spread for third Wednesday dates when quoted outright is typically $6 per metric ton, and the bid-offer spread for an off-cycle date can be far wider and usually not available to trade on screen.  Spreads are tighter for the carry trades between three-month and the third Wednesday dates, where spreads are typically $0.50 per metric ton2.

Replicating the $1 million trade example above using forwards, the contract price is nearly the same at $2,771 per metric ton, and the contract size is also 25 metric tons, requiring a transaction size of 14 lots.  Using the strategy of taking exposure at the three-month date and then moving to a third Wednesday date requires two separate transactions.  Closing out the transaction also involves a carry transaction to move the exposure back to the prevailing three-month date and then finally closing out the trade at the three-month date.  In this scenario, the bid-offer spread that is paid on this whole transaction is the sum of the spread seen at the three-month date and the spread in the carry, which is a combined amount of $2 per metric ton.  For the $1 million transaction in the example, this equates to a cost $700.

It’s of course possible to carry out this whole transaction in an outright third Wednesday date.  This would reduce the impact of exchange fees (see below).  However, the market structure concentrates liquidity away from these dates, and into the three-month date.  With the typical bid-offer spread in third Wednesday dates – as quoted in the on-screen market – being $6 per metric ton, the cost associated with the bid-offer spread for the $1 million transaction, equates to $1,050

Despite three-month forwards being relatively liquid, the structure of the forwards market means that for investors looking to buy and hold the cost can be much higher than for futures.

Exchange fees for forwards can also more complex.  When opening and closing the position using the three-month date and an additional carry trade, this is treated as either four, five, or six transactions for the purpose of calculating fees3.  The non-member fee is $1.96 per lot per transaction4.  For the $1 million trade as a whole, this equates to between $109.76 and $164.64.  Moreover, it’s market practice for non-members to cover their exchange member’s fees, which adds a further 50 percent to the cost, taking the total to between $164.64 and $246.96.  The combined cost from bid-offer spread and exchange fees is, therefore, between $809.76 and $946.96 depending on market practice.

It must be noted that the position could be held at the starting three-month date.  This would provide for the best liquidity and bid-offer spread to open the position, but the liquidity available to close out the trade, either through an outright trade or a carry is generally very thin, and a much higher exit cost ought to be anticipated.

Forwards Transaction

         
               

Opening Trade

           
     

bid

offer

spread

 

fee per lot

Buy

14 lots

3m Aluminium Outright

2771

2772.50

1.50

 

1.96

Buy

14 lots

3m - 20-July-22 Carry

6.25

6.75

0.50

 

1.96

               

Closing Trade

           
               

Sell

14 lots

3m - 20-July-22 Carry

15.50

16.00

0.50

 

1.96

Sell

14 lots

3m Aluminium Outright

2779.50

2781

1.50

 

1.96

               
               
               

Spread Cost

Average spread x Number Lots x Lot Size

     
 

=

((1.50+0.50+0.50+1.50)/2) x 14 x 25

       
 

=

$700.00

         
               

Fee Cost

 

Fee per lot x Number Lots

       
 

=

(1.96 x 14) + (1.96 x 14) + (1.96 x 14) + (1.96 x 14)  

     
 

=

$109.76

         
               

Combined Cost

$809.76

         

Source: Bloomberg LP.  See Footnote 1

Conclusion

In summary, for investors looking for a medium-term exposure to aluminium, or metals more generally, the market structure means that the costs, both in terms of bid-offer spread and exchange fees, can be more nearly even for futures markets and the forwards markets. 

This analysis hasn’t considered the cost of brokerage.  This is a significant part of the cost of a trade but will differ for each investor and each broker.  However, it should be expected that brokerage will be higher where more transactions are carried out and where any off-screen private negotiation is required.  This suggests that these fees may be higher for forwards transactions.

The data for bid-offer spreads and fees in these examples come from publicly available sourcesv.  The forwards market tends to be less transparent than futures, although superior pricing may be available privately.  If your experience of the forwards markets is markedly different from that described above, we’d be very interested to hear from you.

Sources

  1. Data for this analysis is for the one-month period 9 May 2022 to 6 June 2022.  Quotation examples represent price levels on these dates using the modal observed bid-offer spread.
  2. Bid-offer spreads quoted here represent those observed on screen for the period of analysis. Better prices may be available privately, but these would be subjective and cannot be confirmed.
  3. Medium-dated carry trades attract a lower fee, but the availability of this lower fee is not universal and depends on the third Wednesday date chosen.
  4. The calculation provided assumes the best-case scenario for forwards fees, where both carry trades are priced at the reduced fee for a medium-dated carry.
  5. Bid-offer spreads and fees sourced from Bloomberg, CMEGroup.com, LME.com

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All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.

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