Contango Definition, Examples How Does It Work?
Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates. Conversely, a market is considered to be in backwardation when the forward price of a futures contract is lower than the spot price of the commodity. A normal backwardation market—sometimes called simply backwardation—is confused with an inverted futures curve.
Contango is when the futures price is above the expected future spot price. Contango can be caused by several factors, including inflation expectations, expected future supply disruptions, and the carrying costs of the commodity in question. Some investors will seek to profit from contango by exploiting arbitrage opportunities between the futures and spot prices. As the expiration date of the futures contract approaches, the futures price will get closer to the spot price, irrespective of the futures price being at a higher or lower level. In this case, a trader will sell a futures contract for delivery at $60 while also buying enough barrels of oil at the spot price of $50 to fulfil the order at a later point.
The curves in question plot market prices for various contracts at different maturities — cf. „In broad terms, backwardation reflects the majority market view that spot prices will move down, and contango that they will move up. Both situations allow speculators (non-commercial traders) to earn a profit.“ When the market is in backwardation, the futures prices for the commodity follow a downward-sloping curve in which futures prices are below spot prices. Although backwardation is relatively rare, it does occasionally occur in several commodity markets. Causes of backwardation include anticipated declines in demand for the commodity, expectations of deflation, and a short-term shortage in the commodity’s supply. Futures prices above the spot price can be a signal of higher prices in the future, particularly when inflation is high.
A futures contract is a derivative that allows traders to buy an asset at the predetermined price. When at contango, a futures contract trades at a higher price than the commodity’s current price. The contango should not exceed the cost of carry, because producers and consumers can compare the futures contract price against the spot price plus storage, and choose the better one. Arbitrageurs can sell one and buy the other for a theoretically risk-free profit (see rational pricing—futures). The EU describes the two groups of players in the commodity futures market, hedgers or arbitrageurs/speculators (non-commercial investors). The futures or forward curve would typically be upward sloping (i.e. „normal“), since contracts for further dates would typically trade at even higher prices.
The market will then witness a gradual decline in the futures prices toward the spot prices as contracts get closer to their expiration dates, or an arbitrage opportunity would appear where the price of the contract may suddenly move. In all futures market scenarios, the futures prices will usually converge toward the spot prices as the contracts approach expiration. That happens because of the large number of buyers and sellers in the market, which makes markets efficient and eliminates large opportunities for arbitrage.
For perishable commodities, price differences between near and far delivery are not a contango. Different delivery dates are in effect entirely different commodities in this case, since fresh eggs today will not still be fresh in 6 months‘ time, 90-day treasury bills will have matured, etc. Backwardation is when futures prices are below the expected spot price, and therefore rise to meet that higher spot price.
She has conducted in-depth research on social and economic issues and has also revised and edited educational materials for the Greater Richmond area. Thus there is a negative roll return when the market is in ContangoContango. The offers that appear in this table are from partnerships from which Investopedia receives compensation. Investopedia does not include all offers available in the marketplace.
Contango and normal backwardation refer to the pattern of prices over time, specifically if the price of the contract is rising or falling. Markets expect rising prices in futures of the said underlying asset. Review of the difference uses of the words contango, backwardation, contango theory and theory of normal backwardation. Futures prices are shaped by the dynamics between supply and demand for the contracts. Advanced traders can use arbitrage and other strategies to profit from contango. Adam Hayes, Ph.D., CFA, is a financial writer with 15+ years Wall Street experience as a derivatives trader.
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Consider the appropriateness of the information in regard to your circumstances. Please read the relevant product disclosure statement or offer document and obtain appropriate financial advice before making any investment decisions. With over 40 years of combined experience across business Best Way to Learn Java Programming A Step by Step Guide strategy, distribution, marketing, operations and compliance, our high-calibre team promotes and supports a range of strategies across multiple asset classes. In this article, we’ll lay out the differences between contango and backwardation and show you how to avoid serious losses.
Speculators may buy more of the commodity experiencing contango in an attempt to profit from higher expected prices in the future. They might be able to make even more money by buying futures contracts. However, that strategy only works if actual prices in the future exceed futures prices. In a contango situation, the forward price of a commodity’s futures contract will be higher than its spot price.
- Futures prices above the spot price can be a signal of higher prices in the future, particularly when inflation is high.
- CommoditiesA commodity refers to a good convertible into another product or service of more value through trade and commerce activities.
- By the same token, a market that is deeply in contango may indicate a perception of a current supply surplus in the commodity.
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Contango is a situation where the futures price of a commodity is higher than the expected spot price of the contract at maturity. A contango market is also known as a normal market, or carrying-cost market. Understanding whether a market is in Contango or Backwardation enables traders and investors to make their bets in futures correctly. Derivative bets undertaken should take into consideration the impact of futures prices accordingly. It enables markets to interpret that the demand for the underlying asset is expected to rise. It also leads to negative rolling returns as futures prices are always higher than the spot prices resulting in rolling costs for each monthly rollover.
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In the futures markets, the forward curve can be in contango or backwardation. Peak Gold, LLC recently approved an $18 million program to complete a Feasibility Study, ready the project for permitting, and complete further resource definition and exploration drilling. The company believes that there is significant upside exploration on the 675,000-acre land package located in the heart of the Tintina Gold Belt.
Contango is a situation in which the futures price of a commodity is above the spot price. In the case of a physical asset, there may be some benefit to owning the asset called the convenience yield. In the case of a financial asset, ownership may confer a dividend to the owner. At times it may be profitable to hold the tangible commodity rather than holding derivative products in the asset. A contango scenario takes place when the forward price of a futures contract of a commodity is higher than the commodity’s current price, which is why contango is also called forwardation. The company recently formed a new partnership with a subsidiary of Kinross Gold Corporation – The Peak Gold, LLC (Kinross 70% and Contango 30% with Kinross as Manager and Operator).
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For example, using your crystal ball, if you and your counterparty could both foresee the spot price in crude oil would be $80 in one year, you would rationally settle on an $80 futures price. Anything above or below would represent a loss for one of the trading contract pairs. This graph depicts how the price of a single forward contract will typically behave through time in relation to the expected future price at any point in time.
Other costs of carry involve financial, interest and insurance costs. The price difference between futures and spot in contango is mostly related to the cost of carry, which include storing the commodity as well as depreciation costs, and more. An inverted market occurs when the near-maturity futures contracts are higher in price than far-maturity futures contracts of the same type. A futures market is normal if futures prices are higher at longer maturities and inverted if futures prices are lower at distant maturities. In 1993, the German company Metallgesellschaft famously lost more than $1 billion, mostly because management deployed a hedging system that profited from normal backwardation markets but did not anticipate a shift to contango markets. Underlying AssetUnderlying assets are the actual financial assets on which the financial derivatives rely.
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Producers have other reasons to pay more for futures than the spot price, thus creating contango. Producers make commodity purchases as needed based on their inventory. The spot price versus the futures price may be a factor in their inventory management. However, they will generally follow the spot and futures prices while seeking to achieve the best cost efficiency. Some producers may believe that the spot price will rise rather than fall over time.
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A front month, which is also called a near or spot month, is the nearest expiration date for a futures or options contract. The term originated in 19th century England and is believed to be a corruption of „continuation“, „continue“ or „contingent“. In the past on the London Stock Exchange, contango was a fee paid by a buyer to a seller when the buyer wished to defer umarkets review settlement of the trade they had agreed. The charge was based on the interest forgone by the seller not being paid. In a 2010 article in Harper’s Magazine, Frederick Kaufman argued the Goldman Sachs Commodity Index caused a demand shock in wheat and a contango market on the Chicago Mercantile Exchange, contributing to the 2007–2008 world food price crisis.
2008 world food price crisis
That’s because, on the maturity date, the futures price must equal the spot price. If they don’t converge on maturity, anybody could make free money with an easy arbitrage. A few fundamental factors such as the cost to carry a physical asset or finance a financial asset will inform the supply/demand for the commodity. This supply/demand interplay ultimately determines the shape of the futures curve.
A futures contract in contango will normally decrease in value until it equals the spot price of the underlying commodity at maturity. A market is „in backwardation“ when the futures price is below the spot price for a particular asset. In general, backwardation can be the result of current supply and demand factors.
Futures trading based on defined lot sizes and fixed settlement dates has taken over in BSE to replace the forward trade, which involved flexible contracts. Convergence is the movement of the price of a futures contract toward the spot price of the underlying cash commodity as the delivery date approaches. An advantage of contango would be that it can indicate that the price of a commodity may be higher in the future. Contango may also offer an arbitrage opportunity, which could decline as the futures contract nears its expiration date. Contango, sometimes referred to as forwardation, is the opposite of backwardation.