Contango and Backwardation

Amongst the tomes of lingo and jargon new traders will be presented with when trading futures are the terms ‘contango’ and ‘backwardation’. While the principles of both are relatively easy to set out, their role on the trading decisions taken, particularly by hedge funds and speculators, is somewhat more complex to understand and requires a firm grasp of the underlying principles to shape investment decisions.

Furthermore, recognising each of these separate conditions requires an understanding of technical analysis that many new traders are yet to fully comprehend, but in investing the effort to become more closely acquainted with both the terminology and the research processes that go in to identifying contango and backwardation, investors can become more in tune with the markets on which they trade.

Contango

Contango is the term given to describe the situation where the price of a futures contract is greater than the spot price, i.e. the current market rate, expressed graphically by a forward curve that moves in an upwards direction towards the spot price with time. Essentially, this means that the spot price should see convergence with the futures price at some near future point, factoring in the relevant costs of trading and financing the outstanding positions. Contango is a frequent occurrence in commodities markets because there are a variety of other cost bases to factor in to the price equation, such as the cost of warehousing, shipping, insurance etc., born by the seller in the interim until delivery takes place.

Backwardation

Backwardation is the inverse of contango, and the term given to situations where the spot price of an asset is greater than the futures price, i.e. where the price of buying an asset for future delivery is lower than the price of buying the same asset at today’s market value. This is expressed on a chart as a downward curve converging with spot price over time. Backwardation, still a subject of academic debate in the field of economics, is asserted to demonstrate excess future supply of a commodity, given that the value of acquiring the underlying asset today is greater than at some distant future point specified on the futures contract.

So what does this all mean?

Basically, understanding whether a market is in contango or backwardation will have a bearing on whether or not you take long or short positions on your futures contracts. If a commodity, for example wheat, is in backwardation, perhaps as a result of seasonal supply changes, it may be best to consider your trading position accordingly, factoring in the impact of contango on future price movements. Interestingly, markets can also switch from being in a state of contango to backwardation and then reverse again, which can prove problematic for traders relying on one or other of these conditions.

It is recommended that you continue to keep an eye on futures prices in relation to spot prices in order to understand the factors that may be at play in the market, and in doing so it is possible to guard against these shifts in pricing that can prove so costly.

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