RealMoney Readers' Mailbag

Question: How is the spot price of a commodity determined? Jim Cramer says oil prices are demand and supply driven. Some say speculation can influence prices by 20%-30%. If I hold a barrel of oil when the spot is $100 and the one-month future is $120, wouldn't I sell the future for $120 and hold my barrel for next month delivery? If such a scenario is possible, what effect do two prices have on each other? I am confused and would appreciate some discussion on this seemingly simple, but perhaps complex riddle.

--Bob M.

Answer: Stores price their goods inefficiently. They select a price that they think will stimulate the right level of demand. But futures markets are much more efficient. This "price discovery" process provides instantaneous feedback between buyers and sellers.

The forward curve in a futures market in "full carry," the prices at various points in time, are the current cash market price, plus the physical and financial costs of storage. That full carry market should make you indifferent between buying the cash market today and storing it yourself or buying it for future delivery. This is why cash and futures markets trade "in-line" with each other.

Yet once we add insurance costs, price expectations and seasonal factors to that forward curve, it can get distorted in a hurry. If you can sell a cash commodity in the futures market for more than the storage costs noted above, do so. This is a free-money "cash-and-carry" arbitrage. It can exist when supplies are in excess of storage space available at a given cost of storage. In your $100/barrel cash to $120 futures case, you would make a lot of money.

In general, futures get priced off of cash markets whose prices are determined by supply/demand balances, expected replacement costs and all those other things that have earned economics the "dismal science" moniker.

However, many cash markets get priced off of the futures market in what is called a "posting" by the buyer. The cash market looks to the transparent, public futures price, adds or subtracts what are called basis differentials and then trades at that posting until the futures market changes the next day or another appropriate interval.

--Howard Simons

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Question: I have a question for the T.A. people, particularly Dan Fitzpatrick and Alan Farley: How do they set their stops? Market orders that trigger as soon as a stock price falls below a certain level, or do they wait until the close to weed out intraday volatility?

Thanks,
SJS in New Jersey

Answer: I use intraday stop-losses that become marketable orders when hit. I also use trailing stops to manage profitable positions. The placement depends on the trading strategy I'm using for the specific position because I daytrade, as well as swing-trade positions that last several weeks.

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This article was written by a staff member of RealMoney.com.