Convergence, both in theory and practice, is different from divergence. Traders use convergence to refer to a phenomena of the futures price and cash price. Both futures price and cash price of a commodity for instance move closer together over time. In addition, traders use convergence as a way to mention the price action of a futures contract. Futures in this context are derivative financial contacts allowing parties to buy or sell assets at a predetermined future date and price. In this scenario, the buyer could purchase or the seller could sell assets at the set price regardless of the current market price.
Convergence occurs due to an efficient market that will not allow something to trade for two prices at the same time. So, the actual market value of a futures contract is actually lower than the contract price at issue. This is because traders need to factor in the time value of the security. Therefore, when the date of the contract meets expiration, the premium on the time value decreases, thus the two prices move close together or converge. In finance, premium has a few meanings. It sometimes refers to a security trading above intrinsic value, so it is different from a discount. Then it could also refer to the purchase price of an insurance policy. The last meaning refers to the cost to buy an option contract.
Let’s return to the convergence, when the price did not converge, traders take profit of price difference to speed profit. It will somehow go on until the price converges. On the other hand, when prices don’t converge, there is still opportunity available for arbitrage. In this context, arbitrage means the selling and buying of an asset at the same time in the different markets. The purpose of arbitrage is to create a temporary price difference. Most traders use this situation when the market is unfavorable.
