This can be profitable if the price of the commodity is trending higher. Contango refers to when a commodity futures price is above the spot price. For example, let’s say that the spot price of Brent Crude Oil today is $70 per barrel. If you buy a futures contract that expires in two months, if the holder of that contract receives their oil and has to pay $75, this means that the market is in contango. This is because the cost of the forward contract is higher than the spot price or the expected future price. Contango and backwardation are terms to refer to the shape of the futures curve for a given commodity or financial asset.
Make sure you understand an ETF’s approach to this before jumping in. 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. A futures contract in contango will normally decrease in value until it equals the spot price of the underlying commodity at maturity.
- Instead, you are essentially paying the person who sold you the contract to store those goods for you.
- In addition, there’s very little of it in storage globally compared to the amount the world uses on an annual basis.
- Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset.
- Minus the next futures (the date of expiration – December 17, 2020) price.
- The opposite of this, backwardation, is when prices are higher today than in the future.
- It was prevalent in some exchanges such as Bombay Stock Exchange where it is still referred to as Badla.
If the price of oil does rise to $80 he will have saved the company a lot of money. Another example of contango is demonstrated on the following silver chart. This shows the cash price as well as the price of the forward contract two months into the future, with hourly closing prices. During this period, the futures contract trades at a higher price than the spot price, meaning that the market is in contango.
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Contango is normal for a non-perishable commodity that has a cost of carry. Such costs include warehousing fees and interest forgone on money tied up (or the time-value-of money, etc.), less income from leasing out the commodity if possible (e.g. gold). 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. Contango and backwardation are curve structures seen in futures markets based on several factors.
A shrewd refining company, noticing the opportunity, decides to stock up on oil now to lock in its low price. It buys as much oil at current prices as it can store in its tanks, filling them to the brim. Over the ensuing months, the economy regains its footing and the spot price of oil starts to rally back up to the long-term price of $70 per barrel. The refining company, by contrast, gets to keep running through its inventory of $40 oil, locking in fat profit margins for the year. Producers have other reasons to pay more for futures than the spot price, thus creating contango.
Demand for oil suddenly dried up as folks stopped driving to work, flying on airplanes, or otherwise using petroleum products. However, it takes a long time to shut in oil production, meaning that supply was relatively fixed whereas demand was non-existent. This resulted in a massive glut of oil, with nearly all the world’s storage filling up and there being nowhere to put more oil in the short-term. Oil, forex education: trading explanation from the experts in particular—as well as other energy commodities—is subject to a backwardation term structure because short-term supply fears have a tendency to drive up the spot month price. These factors could include weather issues or political instability in the Middle East. Precious metals are less likely to suffer from backwardation, since supply is generally not subject to interruption as energy commodities are.
But while investing in futures may be the most accessible route into these markets, it’s an imperfect one. In particular, investors must understand the 3 sources of return when it comes to futures. The spread price would be subtracted from the average second month price in the event of a contango market. A contango is normal for a non-perishable commodity that has a cost of carry.
Contango vs backwardation
In the futures markets, the forward curve can be in contango or backwardation. The reverse condition where futures trade at a lower price than spot is termed as normal backwardation. Calendar SpreadA calendar spread is a low-risk, directionally neutral strategy that profits from the passage of time and/or an increase in implied volatility. Suppose an individual purchased a futures contract today that matures in one year, and the future spot price is expected to be $80. This is a good situation for speculators who are planning to net long and prefer an increase in futures prices.
Gold contangocreates arbitrage opportunities in this particular metal. Stay updated on the latest products and services anytime, anywhere. This means when trading, it is best not to depend on the market staying in either of these conditions for any length of time.
Further, there is a chance of depreciation of the commodity so they prefer contango fees to postpone the settlement day. Contango and backwardation are vital concepts for anyone wishing to trade commodity futures directly, or invest in exchange-traded funds based on these underlying commodity futures. By understanding these concepts and knowing what impact they will have on commodity investments, it should help investors stay on the right side of the market. The trade would lose money if the market reverts to a normal backwardation structure.
A carrying charge market is a futures market where long-maturity contracts have higher future prices, relative to current spot prices. For example, if the spot price of futures on crude oil is trading $40, while the futures 11 best ways to invest $1,000 on crude oil for delivery in six months is trading $50, that would be described as contango . In this case, it is profitable for traders to sell a physical commodity immediately rather than keep it in storage.
Clarify all fees and contract details before signing a contract or finalizing your purchase. Each individual’s unique needs should be considered when deciding on chosen products. However, some buyers of commodities and futures do not intend to actually take possession of the commodity they are trading for.
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. BackwardationBackwardation is a situation when the futures price of a commodity is lower than the spot price today. However, the commodity’s spot price can be high due to the sudden rise in demand or a disaster triggering the demand. Underlying AssetUnderlying assets are the actual financial assets on which the financial derivatives rely. Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset.
- It also directs the negative rolling return because the future prices are higher than the spot price.
- The cost of carry refers to the cost of “carrying” an asset and affects futures prices.
- For example, in 2009, the calendar spread between the February and March contracts expanded to USD 8, although during the period from 1997 to 2008 the calendar spread stayed within the range from USD -2 to USD +2.
- Then he realizes that the market is in contango where the price of a future in oil is listed at $80/barrel.
The market structure includes premiums or discounts for different grades of commodities as well as processing spreads wherein one commodity is the product of another. It can also include the substitution of one commodity for another, in addition to inter-commodity spreads and calendar spreads. Both contango and backwardation can help shape production because they forecast supply and demand based on future pricing. Placing a stop-loss order can help to minimise risk of gapping and slippage if you plan to trade contracts outright in the futures or forward markets; although these are not always 100% effective.
In order to sell or buy a spread, it is necessary to open two opposite trades simultaneously with the nearest and next contract. Such trades are called a calendar spread and it is one of the arbitrage trading types. The difference between the futures price and asset price is called the basis. Contango is a term used to describe the forward yield curve when it is upward sloping and the price of a future commodity is above that of the spot rate. If cattle futures rise because of a shortage, consumers could decide to buy pork as a substitute if pork is cheaper. At the same time, animal protein producers will attempt to increase supplies of beef to take advantage of the higher prices.
Who uses the futures curve?
Examples would include gold, oil, agricultural products, bitcoin, and volatility on the S&P 500. All of these have various prices at different dates, and thus there’s a curve of prices between today and future contracts. For example, an arbitrageur might buy a commodity at the spot price and then immediately sell it at a higher futures price. As futures contracts near expiration, this type of arbitrage increases. The spot and futures price actually converge as expiration approaches due to arbitrage, and contango diminishes.
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.
Backwardation and Contango in Commodity Trading
Research and trade alerts from a hedge fund pro with a global outlook. A cash market is a marketplace in which the commodities or securities purchased are paid for and received at the point of sale. Samantha Silberstein is a Certified Financial Planner, FINRA Series 7 and 63 licensed holder, State of California life, accident, and health insurance cpt markets review licensed agent, and CFA. She spends her days working with hundreds of employees from non-profit and higher education organizations on their personal financial plans. All Market Updates are provided as a third party analysis and do not necessarily reflect the explicit views of JM Bullion Inc. and should not be construed as financial advice.
In a contangoed market, an investor or trader would buy the short term interest rates if it were expected to fall. In contrast, a trader would be expected to sell in the short term while simultaneously buying future rates assuming that the short term interest rates were expected to rise. Many investors will also lock in a long position even if the price is higher. So they are able to protect themselves from even higher future prices.
Backwardation occurs when the spot price of a commodity is higher than the futures price. In 2009, the calendar spread between the nearest contracts expanded to wild values and there were ‘wild contango’ situations, which lasted for several months. For example, in 2009, the calendar spread between the February and March contracts expanded to USD 8, although during the period from 1997 to 2008 the calendar spread stayed within the range from USD -2 to USD +2. For example, the oil market is in the contango state now because the contracts with more distant terms of delivery are more expensive than the current contract. However, in reality the futures price is often above or below the spot price.