A market that is steeply backwardated—i.e., one where there is a very steep premium for material available for immediate delivery—often indicates a perception of a current shortage in the underlying commodity. By the same token, a market that is deeply in contango may indicate a perception of a current supply surplus in the commodity. Contango is when the futures price is above the expected future spot price. The shape of the futures curve is important to commodity hedgers and speculators.
In general, backwardation can be the result of current supply and demand factors. It may be signaling that investors are expecting asset prices to fall over time. 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.
To go around this, issuers of the commodity ETF use what is known as ‘rolling’. This involves selling near dated futures and buying further dated futures of the same commodity. It is important to note though that rolling also comes with additional trading costs, both in the value of the futures contract and rolling charges. The above price fluctuations explain why market participants are more than willing to engage in contango in the market. It provides a unique opportunity to protect themselves from the unpredictable commodity price swings in the market that can severely puncture their bottom line. For instance, it is common for airline companies to routinely purchase oil futures to bring stability in both their business model as well as their returns.
What Is Contango?
He is a CFA charterholder as well as holding FINRA Series 7, 55 & 63 licenses. He currently researches and teaches economic sociology and the social studies of finance at the Hebrew University in Jerusalem. There are many jobs in finance that require knowledge of contango and backwardation. Explore our CAREER MAP to find the perfect career path for you in corporate finance. Contango is a platform used to acquire, produce, develop, and manage domestic oil and gas assets. We operate in a manner that prioritizes the safety of our employees and the environment.
Contango is a situation where the futures price of a commodity is higher than the spot price. Contango usually occurs when an asset price is expected to rise over time. Contango and backwardation are terms used to describe the observed difference between the spot, or cash, price and futures prices for a commodity. The curve has two dimensions, and plots time across the horizontal axis and delivery price of the commodity across the vertical axis. This guide will break down the key differences between Contango vs Backwardation.
A bullish market is one in which prices make higher highs and higher lows, and this is what a contango situation in the market implies for futures prices. On the other hand, backwardation is a bearish indicator because market participants believe prices will edge lower as time goes on. Consider a futures contract we purchase today, due in exactly one year.
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. Contango, sometimes referred to as forwardation, is the opposite of backwardation. In the futures markets, the forward curve can be in contango or backwardation. Contango is a situation in which the futures price of a commodity is above the spot price. Contango has manifested numerous times in the markets throughout history. As a case, consider the oil price shocks in the 1970s through to the 1980s.
Disadvantages of Contango
Futures prices above the spot price can be a signal of higher prices in the future, particularly when inflation is high. 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.
The difference is normal/inverted refers to the shape of the curve as we take a snapshot in time. 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. Contango and normal backwardation refer to the pattern of prices over time, specifically if the price of the contract is rising or falling.
Who uses the futures curve?
A contango market is also known as a normal market, or carrying-cost market. Whether the situation in a market is contango or backwardation, the fact that at maturity, the forward prices curve converges to meet the spot price offers immense trading opportunities for speculators. During contango, the idea will be to go long on futures contracts as the expectation is that prices will continue drifting higher. But as maturity nears, the idea will be to go short on futures contracts as forward prices converge downwards to meet the spot prices.
In mid-1980, oil was priced above $100 per barrel, but by early 1986, the price had plunged to lows of circa $25 per barrel. In late 1998, the commodity was priced at around $14 per barrel, but it rallied all the way to circa $140 per barrel by mid-2008. There have been more swings since then and as of December 2020, the commodity trades in the $45 – $55 range per barrel. This fee was similar in character to the present meaning of contango, i.e., future delivery costing more than immediate delivery, and the charge representing cost of carry to the holder.
- This is the scenario that famed economist Keynes described in his normal backwardation theory.
- Arbitrageurs can sell one and buy the other for a theoretically risk-free profit (see rational pricing—futures).
- Futures prices above the spot price can be a signal of higher prices in the future, particularly when inflation is high.
- The curve has two dimensions, and plots time across the horizontal axis and delivery price of the commodity across the vertical axis.
- Contango is a situation where the futures price of a commodity is higher than the expected spot price of the contract at maturity.
The definition of contango is a situation where market participants are willing to pay a premium for the future prices of a commodity. They may not desire to pay insurance for the entire period, storage fees, or risk damage, theft or any other unexpected price fluctuations in the market. But even so, at maturity, the forward price curve always converges downwards to match the prevailing spot price. If this does not happen, an arbitrage opportunity will occur in the underlying market that will basically offer “FREE MONEY” to traders. Contango is a situation where the futures price of a commodity is higher than the expected spot price of the contract at maturity.
Both care about whether commodity futures markets are contango markets or normal backwardation markets. 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 describes an upward sloping curve where the prices for future delivery are higher than the spot price (e.g., the price of gold delivered in 1 year is $1,400/oz and the spot price is $1,200/oz). Contango is common in the gold industry, where the commodity is non-perishable and there are storage costs.
What is contango?
A normal backwardation market is often confused with an inverted futures curve. 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. It is important to note that futures contracts have a delivery date – they cannot be held indefinitely. Consumers that want to be delivered the commodities will have no problem when the delivery date is due, but there is a concern for investors that only speculate on the underlying commodity with no intention of actually owning it.
As such, a market in contango will see gradual decreases in the price to meet the spot price at expiration. 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 curves in question plot market prices for various contracts at different maturities orbex forex broker review — 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." A carrying charge market is a futures market where long-maturity contracts have higher future prices, relative to current spot prices.
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A normal backwardation market—sometimes called simply backwardation—is confused with an inverted futures curve. 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. This practice was common before 1930, but came to be used less and less, particularly after options were reintroduced in 1958. It was prevalent in some exchanges such as Bombay Stock Exchange where it is still referred to as Badla.
It would simply be disastrous if these companies would be buying oil at their market prices when required. The purchase of futures contracts helps the companies to plan for stable prices for a guaranteed period. If there is a near-term shortage, the price comparison breaks down and contango may be reduced or perhaps even be reversed altogether into a state called backwardation.
What Is the Difference Between Contango and Backwardation?
Convenience yield exists when carry costs are low and it is beneficial for participants to hold large inventories for the long run. The convenience yield will be low when warehouse stock levels are high and it will be high when warehouse stock levels are low. Backwardation can also occur when producers want to cushion themselves from the price uncertainties in the financial markets. This is the scenario that famed economist Keynes described in his normal backwardation theory. 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.
Over the long run, the actions of market participants rebalancing their portfolios can impact asset prices. When futures contracts are bought, the increase in demand causes an increase in short term prices. But now, with the market flooded with future supply, prices consequently come down, effectively removing contango from the market.
When maturity is still far away, speculators can go short as future prices are expected to edge lower. But as maturity nears, the idea will be to go long as forward prices converge upwards to meet the spot prices. The conclusion is that both contango and backwardation simply reflect the opposite sides of the same coin. They also both offer exciting opportunities for both short term and medium-term speculation.
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Samantha Silberstein is a Certified Financial Planner, FINRA Series 7 and 63 licensed holder, State of California life, accident, and health insurance 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. Think of hedging a trading strategy or using your NFT as collateral to cmc markets: an overview borrow other assets. 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 settlement of the trade they had agreed. The charge was based on the interest forgone by the seller not being paid.
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. An inverted market occurs when the near-maturity futures contracts are higher in price than far-maturity futures contracts of the same type.
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. As we approach ayondo forex broker review contract maturity—we might be long or short the futures contract—the futures price must move or converge toward the spot price. 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.
As mentioned, in contango, forward prices are higher than spot prices. The opposite phenomenon is backwardation, where forward prices are lower than the spot price. In contango, forward prices trade at a premium to spot prices mostly due to high carrying costs. These are costs, such as storage fees, cost of financing or insurance charges. Because the opinions and perceptions of market participants change continuously, forward price curves in the market can easily toggle between contango and backwardation. A backwardation forward curve will show lower future prices and higher spot prices.