Cost of Carry (CoC) refers to the cost traders have to bear for holding a position in the market. It is a crucial aspect of trading in almost all types of markets. As you know, holding an investment position in any market comes with a cost. For instance, market costs and opportunity costs are included in CoC. Furthermore, these costs also depend on the position an investor holds in the particular market.
If you want to know all about the Cost of Carry, then you are on the right platform. In this article, we are going to define and explain CoC, how to calculate, and use it. So, let’s begin right away.
Cost of Carry
Every investment an investor holds accompanies certain costs that are known as Cost of Carry. These costs can include any cost that comes with an open investment position and includes financial costs, opportunity costs, etc. It is also an important calculation in the derivative market where it helps in determining the future price of an asset.
In the simplest words, Cost of Carry refers to all costs that accompany an open investment position. These costs can be financial costs such as interest paid on loans taken for the investment, interest costs on margin accounts, etc. Other costs such as opportunity costs and costs of storing physical assets are also included in CoC. Now, it is one of the most important aspects that investors should consider before opening a position.
Cost of Carry in futures trading
Although investors use the Cost of Carry while holding a position in any type of market, it is widely used in the derivatives market. In the futures market, CoC is the cost an investor bears for holding a position in the underlying market till the expiry of the future contracts. This cost includes a risk-free interest rate while the dividend payout is subtracted from the total cost. You can calculate CoC using the following equations.
CoC = Futures price – spot price of the underlying security
Futures price = Spot price + CoC
So, we can say that CoC helps in determining the fair price of the future. To be more specific, it is important to subtract any dividend payout. Thus, the equation becomes;
Futures fair price = Spot price + CoC – dividend payout
Now, the most important question is “how to interpret Cost of Carry?” Analysts and investors use it to gauge market sentiment. For instance, low CoC means the value of the underlying security has decreased and investors are not willing to bear higher costs to hold the position. Contrarily, an increased CoC means the value of the underlying security has increased and investors are in favor of holding the position despite a higher CoC.
The next important question is “Can CoC be negative?” Well, the answer is yes because it is quite possible. How so? As you know, often it happens that futures get traded at a discount to the underlying. So, what should be the CoC in such cases? Obviously, it will be negative and can be because of an expected dividend payout or when investors aggressively execute a reverse arbitrage strategy. A reverse arbitrage strategy involves selling futures and buying spots.
CoC and market sentiment
Furthermore, the Cost of Carry also helps in determining bullish or bearish sentiment in the market. Changes in CoC combined with open interest make it easy for analysts to determine the broader sentiment of the market. Here open interest refers to the total number of open positions in a particular futures contract. An increase in CoC along with open interest indicates bullishness because of accumulated long positions. That means Investors are opening long positions because of their bullish sentiment. Conversely, a decrease in CoC along with rising open interest indicates bearishness because of accumulated short positions. In other words, Investors are opening short positions because of their bearish outlook.
Now, if open interest falls and a rise in CoC accompanies, it indicates investors are closing their opened short positions. Conversely, if both open interest and CoC fall, it indicates that investors are closing long positions. Simply put, you can gauge the prevailing market sentiment by looking at both Cost of Carry and open interest.
How to calculate net return?
Cost of Carry factors influence net returns of an open position and it is important to consider it while calculating net returns. It gives a better view of how much you actually made or lost. If you don’t consider CoC for net return calculations, you get an inflated output.
- You should subtract interest paid on margin when using margin.
- Subtract dividends are missed due to short selling as an opportunity cost from net returns from short selling.
- Subtraction of interest paid on any loans taken for an investment is important for getting an actual net return on your investment.
- The trading commission also includes in Cost of Carry and should be subtracted from net returns.
- For markets such as commodity markets where storage costs are significant, you need to subtract storage costs from net returns.