The Physics of Time: Term Structure
Understanding the Cost of Carry, Forward Curves, and why 'Rolling' kills returns.
Futures prices are not merely predictions of the future; they are mathematical projections of the spot price based on the Cost of Carry. Arbitrageurs enforce this link. If the future deviates from this cost, risk-free profit exists.
Cost of Carry Model
Deconstructing the Formula
Price driven by interest rates. Storage is cheap (vaults/electronic).
Price driven by tank space and scarcity. Storage is expensive.
The Mechanics of "The Roll"
Speculators rarely take delivery. Before expiry, they must "Roll" (Close the expiring contract, Open the next month).
The Treasury Complex
Embedded Options, The 'Wildcard', and the anatomy of the Basis Trade.
The Liquidity Smile
The US Treasury Yield Curve is not a smooth line. The most recently issued bonds (On-the-Run) trade at a premium (lower yield) because they are highly liquid. Old bonds (Off-the-Run) trade at a discount.
Short OTR (Expensive) / Long OFTR (Cheap). Bet on spread convergence.
In a crisis, "Flight to Quality" widens the spread. Everyone wants OTR; nobody wants OFTR.
Essential Commodity Spreads
Processing margins and Inter-market relationships.
Crack Spread
Buy 3 Crude Oil → Sell 2 Gasoline + 1 Heating Oil.
This measures the refining margin. If the spread tightens, refiners slow production, eventually causing product shortages (Gasoline prices rise).
Crush Spread
Buy Soybeans → Sell Soybean Meal + Soybean Oil.
Measures the profit of processing beans. Meal is for animal feed, Oil is for cooking/biodiesel. Often trades in opposite directions based on Chinese demand vs Energy demand.
The Widowmaker
Long March (Winter) / Short April (Spring).
Known for extreme volatility. It bets on how much gas is left in storage at the exact end of winter. It has bankrupted hedge funds (e.g., Amaranth Advisors) due to weather unpredictability.
The Delivery Timeline
The critical dates where 'Paper' becomes 'Physical'. The danger zone for speculators.
Retail Warning
Most retail brokerages will force liquidate your position 24-48 hours before First Notice Day to prevent accidental delivery.
Physical Delivery Anomalies
When logistics fail: Negative prices in Energy and Power.
WTI Crude Oil (April 2020)
Oil futures require physical delivery at Cushing, Oklahoma. In April 2020, global lockdowns killed demand, and Cushing storage hit 100% capacity. Long holders (ETFs, speculators) had no place to put the oil. They had to PAY buyers to take the contracts off their hands to avoid breaching delivery contracts.
The Lesson
Commodity prices have a "soft floor" (storage costs) and a "hard floor" (zero). But when storage is full, the floor disappears. Prices can theoretically go to negative infinity.
Waha Gas Hub
Natural gas in West Texas is a byproduct of oil drilling. If pipelines break, gas is stranded. Producers will pay -$5.00/MMBtu just to get rid of it (flaring is regulated) so they can keep pumping the profitable oil.
Negative Electricity
Wind farms get tax credits (PTC) for generating. If the credit is $25/MWh, they will happily sell power at -$10/MWh because they still net $15 profit. This forces baseload nuclear/coal plants to pay to stay online.
Agricultural Specials
Quality discounts and the 'Lemon' problem.
The Vomitoxin Discount
In grain markets, futures specs allow for delivery of lower quality grain at a discount. In a bad crop year, only "dirty" wheat (high vomitoxin levels) is available for delivery.
- • Futures track the "dirty" wheat price (low).
- • Cash market needs "clean" wheat (high price).
- • Result: Basis blows out. Hedges fail because the future doesn't protect the value of the clean crop.
Coffee "C" Differentials
The ICE contract allows delivery from 20 countries. Traders will always deliver the cheapest origin allowed (e.g., Honduras vs Colombia).
Market Microstructure
Gamma squeezes, LME Queues, and Hidden Risks.
Gamma Squeeze
When dealers sell Out-of-the-Money (OTM) calls, they are short gamma. As price rises, they must buy futures to hedge. This buying drives price higher, forcing them to buy MORE. This creates an explosive vertical move.
LME Warehouses
Warehouses (often owned by banks/traders) intentionally create queues to slow down metal load-out. This generates rent revenue. It disconnects the LME price from the actual physical premium paid for immediate metal.
Stop Hunts
In thin markets (Asian session for US Treasuries), algos may push prices into known areas of liquidity (stop losses) to trigger volume. Once the stops are cleared, price often reverses immediately.