Contango vs Normal Backwardation: What’s the Difference?
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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.
- Adam Hayes, Ph.D., CFA, is a financial writer with 15+ years Wall Street experience as a derivatives trader.
- 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.
- This involves selling near dated futures and buying further dated futures of the same commodity.
- Causes of backwardation include anticipated declines in demand for the commodity, expectations of deflation, and a short-term shortage in the commodity’s supply.
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, fusion markets forex broker review 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.
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.
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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.
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.
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.
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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 — 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.
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.
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 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.
Contango Meaning, Why It Happens, and Backwardation
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.
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.
Contango: Understanding Advanced Commodities Trading
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.
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.
The Convergence of Futures Prices and Expected Spot Prices
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 what is hugofx 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.
Who uses the futures curve?
A futures market is normal if futures prices are higher at longer maturities and inverted if futures prices are lower at distant maturities. Fortunately, the loss caused by contango is limited to commodity ETFs that use futures contracts, such as oil ETFs. Gold ETFs and other ETFs avatrade broker review that hold actual commodities for investors do not suffer from contango. Backwardation describes a downward sloping curve where the prices for future delivery are lower than the spot price (e.g., the price of oil delivered in 3 months is $40/bbl and the spot price is $50/bbl).
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.
Economic theory
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.
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.
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.
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.