Contango
What Is Contango and How Does It Work?
A scenario in which the futures price of a commodity is greater than the spot price is known as contango. When the price of an asset is predicted to rise over time, it is said to be in contango. As a result, the forward curve slopes upward.
TAKEAWAYS IMPORTANT
A scenario in which the futures price of a commodity is greater than the spot price is known as contango.
As contracts near expiration, futures prices will normally converge toward spot prices in all futures market circumstances.
Advanced traders can profit from contango by employing arbitrage and other tactics.
Contango usually results in losses for investors in commodity ETFs that employ futures contracts, but these losses can be avoided by investing in ETFs that contain actual commodities.
Understanding The price of a Contango Futures contract is affected by supply and demand at each available expiry. Investors prepared to pay more for a commodity in the future are said to be in contango. The cost of carry is commonly defined as the premium over the current spot price for a specific expiry date. Any charges an investor would have to pay to retain an asset for a period of time are included in the cost of carry. The cost of carry for commodities often includes storage costs as well as depreciation due to spoilage, rotting, or deterioration in some circumstances.
As contracts near expiration, futures prices will normally converge toward spot prices in all futures market circumstances. This is due to the vast number of buyers and sellers in the market, which makes markets efficient and reduces arbitrage opportunities. As a result, in a market in contango, the price will gradually decline to reach the spot price at expiry.
Futures markets, on the whole, include a lot of speculation. Contracts that are closer to their expiration date are more speculative. An investor may want to lock in a higher futures price for a variety of reasons. As previously stated, one of the most prominent reasons for purchasing commodities futures is the cost of carry.
Other factors motivate producers to pay more for futures than the spot price, resulting in contango. Producers buy commodities as needed, based on their stockpile. Their inventory management may be influenced by the spot price against the futures price. They will, however, typically track spot and futures pricing in order to maximise cost efficiency. Some manufacturers may assume that, over time, the spot price would climb rather than decline. As a result, they
Backwardation vs. Contango
Contango, sometimes known as forwardation, is the polar opposite of backwardation. The forward curve in futures markets can be in contango or backwardation.
When the futures price for a given item is lower than the spot price, the market is said to be "in backwardation." Backwardation can be caused by current supply and demand issues in general. It might indicate that investors expect asset prices to decline over time.
The forward curve of a market in backwardation is downward sloping, as seen below.
Contango's Advantages and Disadvantages
Contago's Benefits
Arbitrage methods are one approach to profit from contango. An arbitrageur, for example, would buy a commodity at the spot price and then sell it at a higher futures price. This form of arbitrage becomes more common as futures contracts approach expiration. Due to arbitrage, the spot and futures prices converge as expiry approaches, and contango decreases.
There's also a different way to profit from contango. When futures prices are higher than spot prices, it might be a hint that prices will rise in the future, especially if inflation is strong. Speculators may buy more of the commodity in contango in the hopes of profiting from higher predicted future prices. By purchasing futures contracts, they may be able to make even more money. That method, however, only works if real future prices surpass futures prices.
Attempting to benefit from contango sometimes necessitates taking risks that are unsuitable for most individual investors.
Contango's disadvantages
Automatically rolling forward contracts, which is a popular method for commodities ETFs, are the most major downside of contango. When markets are in contango, investors who buy commodities contracts lose money when the futures contracts expire higher than the spot price.
Fortunately, contango only affects commodities ETFs that trade in futures contracts, such as oil ETFs. Contango does not affect gold ETFs or other ETFs that hold physical commodities for investors.
What Causes Contango and How Can It Be Prevented?
Contango can be triggered by a variety of variables, including inflation expectations, anticipated future supply problems, and the commodity's carrying costs. Some investors will look for arbitrage possibilities between futures and spot prices to profit from contango.
What Is the Difference Between Backwardation and Contango?
Backwardation is the polar opposite of contango. When the market is in backwardation, the commodity's futures prices follow a downward-sloping curve, with futures prices being lower than spot prices. Although backwardation is uncommon, it does occur on occasion in a number of commodities markets. Expected decreases in demand for the commodity, fears of deflation, and a short-term supply deficit are all causes of backwardation.
How Do Commodity Exchange-Traded Funds (ETFs) Affect Contango?
Investors in exchange-traded funds (ETFs) should be aware of how contango affects certain commodity-based ETFs. In particular, if a commodities ETF invests in commodity futures contracts rather than physically owning the commodity in question, the ETF may be obliged to replace—or "roll over"—its futures contracts when they expire. If the commodity in issue is susceptible to contango, the prices paid for these futures contracts will continue to grow steadily. This can considerably raise the ETF's costs in the long run, lowering the profits obtained by its investors.
