Contango refers to a situation in which the price of a commodity or security in the future (known as Futures Price) is more than the price of such commodity or security at present (known as Spot Price). It is a normal practice for financial instruments to be in contango as future price should trade at a premium to spot prices to take care of various factors such as risk-free rate, convenience yield, etc. In short, it denotes a normal market scenario where longer-dated securities trade higher than shorter-dated securities.
The Equation term can be quoted as-
Ft > St
- Ft denotes Futures Price and
- St denotes the Spot PriceSpot PriceA spot price is the current market price of a commodity, financial product, or derivative product, and it is the price at which an investor or trader can buy or sell an asset or security for immediate delivery. of the underlying assetUnderlying 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. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates..
The point arises why markets remain in ContangoContango, i.e., spot prices are lower than forward prices. Major reasons that contribute to the same are enumerated below:
- Markets expectation of rising in prices in futures of the said underlying asset.
- Convenience Yield is lower than interest rates.
- Demand for the underlying asset, seasonality effects also affect and contribute to this impact (This is especially prevalent in the case of commoditiesCommoditiesA commodity refers to a good convertible into another product or service of more value through trade and commerce activities. It serves as an input or raw material for the manufacturing and production units. such as fuel, etc.)
Example of Contango
In the practical world, most of the futures contract is undertaken with the intent to settle them on or before expiry on a cash basis with no real exchange of assets through delivery, and that makes understanding it even more important.
XYZ Portfolio managerPortfolio ManagerA portfolio manager is a financial market expert who strategically designs investment portfolios. had entered long on a futures contract of crude oil when the futures price of June 2019 expiry was quoting at $65. The spot price at that time was $63.50. Therefore futures were trading at a premium of $1.50 over the spot price, and as such, the market is in ContangoContango (Futures Price is higher than Spot Price). At the end of the month, expiry XYZ decided to roll over the futures contract to July month; however, at that time, the spot price was trading at $65, and the futures price was trading at $66. Therefore futures were trading at a premium of $1.Due to the reduction in premium price from $1.5 to $1, the portfolio manager will suffer a loss on roll return as stated below:
- Roll Return = (June Futures Price-July Futures Price)/June Futures Price
- = ($65-$66)/$65
- = (1.54%)
Thus there is a negative roll return when the market is in ContangoContango.
Similarly, if the futures price of July month was quoting at $64 and as such, the market is in backwardationBackwardationBackwardation is a situation when the futures price of a commodity is lower than the spot price today. It is a rare situation and doesn't last long. However, the commodity's spot price can be high due to the sudden rise in demand or a disaster triggering the demand. (Spot Price is higher than Futures Price), the portfolio manager will gain on rolling of its position as stated below:
- Roll Return = (June Futures Price-July Futures Price)/June Futures Price
- = ($65-$64)/$65
- = 1.54%
Thus there is a positive role return when the market is in backwardation.
Difference between Contango and Backwardation
|Definition||It refers to a situation where the futures price is higher than the spot price.||It refers to a situation where the spot price is higher than the future price.|
|Major Cause||Future demand for the underlying asset results in futures prices higher than the spot price.||Lower Future demand or excess supply in the future for the underlying asset results in futures prices lesser than the spot price.|
|Strategy||When the market is in ContangoContango, traders can gain by buying at spot prices and selling in futures.||When the market is in backwardation, traders can gain by selling at spot prices and buying in futures.|
|Hedge Cost||It increases the rolling cost of the hedge.||It decreases the rolling cost of the hedge.|
|Futures Curve||It happens when the futures curve is upward sloping.||It happens when the futures curve is downward sloping or inverted in nature.|
|Hedging Pressure Hypothesis||Under this, users’ hedging behavior dominates.||Under backwardation, producers hedgingHedgingHedging is a type of investment that works like insurance and protects you from any financial losses. Hedging is achieved by taking the opposing position in the market. behavior dominates.|
|Cost of Storage and Holding of Physical Asset||When the costs of storing the asset/inventory outweigh the benefits of holding physical assets/inventory, futures are more attractive than current inventory, and futures will trade at a higher price than the spot price, and the market will be in ContangoContango.||When the benefits of holding physical asset/inventory outweigh the costs of storing the asset/inventory, holding the asset today are more attractive than holding it in future resulting in spot prices higher than future price and the market will be in backwardation.|
|Calendar Spread and Basis||In this market, the calendar spread( Difference between the future price of a near maturity and future price of a distant maturity) and basis (Difference between spot market price and the futures price for a date in future period) are negative.||In a backwardation market, the calendar spread and basis are positive.|
|Rolling Return||Roll return (Return from the closing of maturing futures contracts and replacing them with new future contracts of higher maturity) is negative when a futures market is in ContangoContango because the longer-dated contracts of future expiry are priced higher than the contracts in the near term which are expiring.||Roll Return is positive when a futures market is in backwardation because the longer-dated contracts of future expiry are priced lower than the contracts in the near term, which are expiring.|
|Term Structure||Under this, the term structureTerm StructureThe term structure is the graphical representation that depicts the relationship between interest rates and various maturities. The graph itself is called a “yield curve.” The term structure of interest rates plays an essential part in any economy by predicting the future trajectory of rates. has a positive slope.||Under this, the term structure has a negative slope.|
It is important to note that just like Contango differs from “Normal Contango.” A Normal Contango refers to a situation in which the futures price is greater than the expected spot price.
Understanding whether a market is in Contango or Backwardation enables traders as well as investors to make their bets in futures correctly. Derivative bets undertaken should take into consideration the impact of futures price accordingly. It enables markets to interpret that the demand for the underlying asset is expected to rise in the future. It also leads to negative rolling returns as futures prices are always higher than the spot prices resulting in rolling cost for each monthly rollover.
This has been a guide to What is a Contango & its Definition. Here we discuss key differences between Contango and Backwardation along with important points, examples, advantages & disadvantages. You can learn more about from the following articles –