Contango and Backwardation: Understanding the Basics
If you're familiar with the futures trading, you are highly likely to be heard of such words as "contango" and "backwardation". But if you still did not hear about these concepts - we're here to help! Hope this article can help you to get more familiar with these terms and turn the weakness into the strength.
The understanding of futures backwardation is explained pretty well in the «Trading Spreads and Seasonals» by Joe Ross. If you have not dropped this article yet, this book is highly recommended for you to read.
What are contango and backwardation?
Contango and backwardation are connected with the shape of the Forward curve of a commodity, for example, gold, silver, wheat or crude oil. A forward curve can be plotted on a chart of a particular contract by using an X and Y axis.
The X axis is about various contract expiration dates. Corresponding, the Y axis contains the respective futures prices. If you see a rising slope with a future contract rising in time — your futures curve is normal.
This structure is also called contango - when the cost of future contracts is more expensive than nearby contracts.
But if your futures curve is inverted, it represents a falling slope as the prices of futures contracts gets lower with time.
This is backwardation - when the cost of future contracts is cheaper than nearby contracts.
How do you know if the market is in contango or backwardation? If the long-term futures contracts are trading at a premium to the spot price, that means that you're facing a contango market. Curve structures, like contango and backwardation, can be seen in futures markets based on several factors. Don't forget that the futures price eventually converges on the spot price, so any gaps between the futures price and the spot price will close as contract expiration nears.
For example, if the price of current month of Brent Oil is $52.55 and the price of the seven month is $52.11, so there is backwardation structure.
A normal market, as known as a normal futures curve, demonstrates that the cost to carry is increasing depending on time. Accordingly, an inverted futures curve or such market shows that the pricing for further out deliveries is less than the current spot price. Some sorts of geopolitical events, shortages or surprising weather concerns could serve as the cause of such type market structure.
If we were asked to explain the contango and backwardation to a newbie trader, this is what we'd say: if the future price is anticipated to be more expensive than the spot price — you have a contango, but when the future price is anticipated to be less expensive than the spot price — you're happy to face backwardation.
The Cost of Carrying
The cost of carrying is one of the most important factors affecting the prices of futures contracts. The insurance cost and the cost of storage are the leading factors in creating the cost of a carrying if we talk about commodities. If you're trading in the capital markets, the cost of carrying depends on the cost of funds to finance a position and the difference between the interest generated on a cash instrument.
For financial assets, you can define future value via the following formula:
Future Value = Spot value + Financing + Storage costs – Cash Yield
It is hard to tell in which state markets spend more time. Some potential issues, associated with the market, can lead it to the lasting state of backwardation. That's likely to happen if some resource's refinery needs to shut down for maintenance, that means the drop of a refining capacity and results in the potential rise of the price of delivery for this resource.
How does a Contango arise?
What is the reason of contango situations? Dealing with any kind of commodity means some outlay before it is ready to be sold. It is all about:
- insurance costs
If the market is stable and there is no inflationary contango equals the costs price. If our commodity is seeds, so the contango price could be equal to the warehousing price. But if the commodity has short expiration date — contango term can't be used. The market expectations should be mentioned among the other influences of market players because panics and fear of crisis can influence the market, decrease the contango and provoke the backwardation.
Difference between backwardation and contango
For sure, the phenomenon of backwardation can be considered as the futures market pathology. Theoretically, futures contract price should be equal the price of an asset, but if the asset's price is higher than the contract's price — you're lucky to face the backwardation in its finest. It is common for the perishable products trading. Contango is the reverse situation. The price difference between an asset and futures can be called "spread", but usually it is known as a "basis".
Previously mentioned Joe Ross and the other futures trading authorities are having a general agreement on the fact, that the futures contract that will be executed next month is more valuable than the one that is going to be executed in a few months. Why so? Because you have to consider a number of costs such as warehousing, credits, and insurance. But the reverse situation is also probable to happen. Sometimes traders agree to pay cash to get the commodity now, not few month later. Whether you like it or not, you should know how to act while facing both of these market cases.
Contango investment strategies
Trader's behavior could differ depending on the situation. If the market is stable, which is likely to be the contango case, it is more profitable to invest in the stocks, not the futures or papers. Futures appear to be much more profitable while backwardation. That results in the fact, that the real players should not just be ready to take into account the influence of contango or backwardation, but also to be familiar with the fact that these two situations can replace each other, which will definitely influence the income flow dynamics.
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