What is contango? Investing Definitions

Contango offers numerous clues and opportunities for investors who trade in commodities. This situation alerts traders to dislocations in the market, such as higher-than-expected inflation, supply disruptions or increased demand. Investors who act quickly can also take advantage of arbitrage opportunities when contango occurs. In this scenario, the investor would buy the commodity at the spot price, then turn around and immediately sell it at a higher futures price.

Contango describes an upward sloping curve where the prices for future delivery are higher than the spot price (e.g., the price of gold delivered in 1 year is $1,400/oz and the spot price is $1,200/oz). Contango is common in the gold industry, where the commodity is non-perishable and there are storage costs. A shrewd refining company, noticing the opportunity, decides to stock up on oil now to lock in its low price. It buys as much oil at current prices as it can store in its tanks, filling them to the brim.

In this scenario, the trader would make a profit of $10 on each barrel of oil while storing the physical oil for a few months. Contango and normal backwardation refer to the pattern of prices over time, specifically if the price of the contract is rising or falling. Demand for oil suddenly dried up as folks stopped driving to work, flying on airplanes, or otherwise using petroleum products. However, it takes a long time to shut in oil production, meaning that supply was relatively fixed whereas demand was non-existent. This resulted in a massive glut of oil, with nearly all the world’s storage filling up and there being nowhere to put more oil in the short-term. For example, if oil is in a state of contango, you could potentially buy lower-cost airfare now.

Placing a Spread Trade

If you see lumber and other building materials in contango, you could save money on construction and home renovations rather than later when prices go up. Businesses might also stock up on commodities during periods of contango. For example, this could happen if investors expect a future supply surge for a commodity, a major drop in demand, or the economy is in a state of deflation, where prices are falling usually due to a recession. Float rotation describes the number of times that a stock’s floating shares turn over in a single trading day. For day traders who focus on low-float stocks, float rotation is an important factor to watch when volatility spikes.

In a normal contango market, an ETF will buy the forward month futures while selling the spot or current month contracts to keep an average inventory for a 30-day period. However, ETFs can’t roll over futures, instead they buy the further out futures at a higher price to replace the current futures being sold at a lower price. This is why leveraged ETFs like the UVXY tend to lose 8 to 13% monthly during low volatility periods. Long-term investors should never hold these ETFs in a portfolio as the time decay erodes value. To understand why contango matters, it’s important to know how futures trading typically works.

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.

As the expiration date of the futures contract approaches, the futures price will get closer to the spot price, irrespective of the futures price being at a higher or lower level. In this case, a trader will sell a futures contract for delivery at $60 while also buying enough barrels of oil at the spot price of $50 to fulfil the order at a later point. Contango refers to a situation when the price of a futures contract of a commodity exceeds its spot price. This creates an upward sloping forward curve, which indicates that the price of the asset is expected to rise over time. Some commodities go through seasonal fluctuations that have them sometimes in contango and other times in backwardation.

Contango In The Oil Market

This trade would profit if the market increases its contango structure. On the other hand, markets in backwardation may be bullish on spot prices, as a result of shortages. Supply shortages can push spot prices higher due to intense competition over limited availability, which is why spot prices trade at a premium to futures prices in this environment.

• Short squeezes can introduce a lot of volatility into stocks and send share prices sharply higher.
• Looking at an example, imagine crude oil is currently trading $70 per barrel (for immediate delivery).
• When trading commodities like iron ore, crude oil or wheat, the price of an asset for immediate delivery is known as the spot price.
• In general, backwardation can be the result of current supply and demand factors.
• In addition, there’s very little of it in storage globally compared to the amount the world uses on an annual basis.

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. A normal forward curve depicting the prices of multiple contracts, all for the same good, but of different maturities, slopes upward. For example, a forward oil contract for twelve months in the future is selling for $100 today, while today’s spot price is $75. The expected spot price twelve months in the future may actually still be $75. On average, historically, the price of next month’s volatility is generally around 5-10% above the current month’s volatility futures price.

What was a recent market example of contango?

This shows that investors expect the price of the commodity/financial asset to go up in the future. 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. Because investors base their futures bids on how they foresee the market turning out, sentiment plays a significant part in backwardation. Investors might anticipate a declining market and begin to sell short futures contracts with strike prices below the current spot price and buy the contracts for a profit. In this situation, a trader who controls physical barrels of oil and has access to storage can easily lock in a profit.

In the chart below, the spot price is higher than future prices and has generated a downward sloping forward, or inverted, curve which is in backwardation. The futures forward curve may become backwardated in physically-delivered contracts because there may be a benefit to owning the physical material, such as keeping a production process running. This is known as the convenience yield, which is an implied return on warehouse inventory. When warehouse stocks are high, the convenience yield is low and when stocks are low, the yield is high. Commodity futures contracts let investors purchase commodities to be delivered in the future. Contango theory is when the price of the futures contract is higher than the expected spot price on the day of the contract’s delivery.

How to Recognize a Short Squeeze

Have you ever seen a stock exhibiting normal trading behavior and then all of a sudden the stock price drastically drops out of nowhere? This type of price action could be related to the announcement of a shelf offering or the execution of an “at-the-market” sale from… Further information on each exchange’s rules and product listings can be found by clicking on the links to CME, CBOT, NYMEX and COMEX. SmartAsset Advisors, https://1investing.in/ LLC (“SmartAsset”), a wholly owned subsidiary of Financial Insight Technology, is registered with the U.S. SmartAsset does not review the ongoing performance of any RIA/IAR, participate in the management of any user’s account by an RIA/IAR or provide advice regarding specific investments. The term originated in 19th century England[20][21] and is believed to be a corruption of “continuation”, “continue”[22] or “contingent”.

Contango is a situation where the futures price of a commodity is higher than the spot price. Contango usually occurs when an asset’s price is expected to rise over time. The takeaway lessons here are traders is to be very cautious holding any leveraged or commodity ETFs beyond a short-term time frame. It also helps to be aware of the underlying mechanics behind how these ETFs mirror the performance of the index or commodity.

In particular, for a market that’s in contango, the price of the replacement futures contract will be higher than the price of the contract that just expired. That creates a small amount of friction that over time can add up to a huge downward pull on the return for a given futures investment compared to the spot price of the underlying product. Most commodity ETFs use rolling contracts, where they keep exchanging their existing short-term futures contracts before they expire for new ones. If prices go up, they lose money on the exchange each time, hurting their performance. Overtime, arbitrage—buying and selling an asset simultaneously in different markets to take advantage of price differences—opportunities are reduced because futures prices and spot prices converge. Equity options follow contango pricing, where long-dated options carry a higher premium than the front month options.

Conversely, a market is considered to be in backwardation when the forward price of a futures contract is lower than the spot price of the commodity. In case of physical assets such as commodities, the cost of carry mostly comprises storage costs and depreciation due to spoilage, decay or rotting. Other costs of carry involve financial, interest and insurance costs. A futures market is normal cash and carry model if futures prices are higher at longer maturities and inverted if futures prices are lower at distant maturities. Futures contracts are very useful in some cases, but they have risks that most stock investors don’t know about. By being aware of contango and backwardation, you can identify potential long-term threats to your portfolio that others will miss, avoiding nasty and costly mistakes.

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Tasty Software Solutions, LLC is a separate but affiliate company of tastylive, Inc. Neither tastylive nor any of its affiliates are responsible for the products or services provided by tasty Software Solutions, LLC. Cryptocurrency trading is not suitable for all investors due to the number of risks involved. The value of any cryptocurrency, including digital assets pegged to fiat currency, commodities, or any other asset, may go to zero.

For example, one crude oil futures contract is for 1,000 barrels and defines when trading stops, how the contract is settled, the minimum price fluctuations, and more. Due to the global demand freeze from the effect of COVID-19 and oversupply, buyers actually refused to take delivery due to the carry costs of storage. In fact, the buyers were paying not to deliver the oil, which is how the contract price went negative. Even if you don’t trade futures contracts, contango could make a material impact if you trade ETFs that trade underlying index of commodity futures.

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Level 1 vs. Level 2 Market Data

Consider working with a financial advisor when preparing to invest in commodities to ensure that your moves fit your risk profile, goals and timeline. Oil is a unique market since it is crucial to major industries including transportation, energy, chemicals, agriculture, and many more. In addition, there’s very little of it in storage globally compared to the amount the world uses on an annual basis. Unlike, say, silver or platinum, it’s easy to end up with way too much – or too little – oil virtually overnight. He specializes in making investing, insurance and retirement planning understandable. Before writing full-time, David worked as a financial advisor and passed the CFP exam.

On the positive side, ETFs that hold actual commodities, such as gold ETFs, are not affected by contango. Contango, also called forwardation, is the pricing situation found with futures contracts where longer-dated futures consecutively trade at higher prices than the spot (current period) contracts. Usually, time premium and/or carry costs (for commodities) normally makes long-dated (further out) futures more expensive then near-term or current month futures. In a normal market, longer-dated futures contracts are priced higher than current spot prices, due to inflation and the risk of other unknown market factors that may develop over time.

• On the other hand, markets in backwardation may also arise due to supply shortages.
• Backwardation could indicate that traders are anticipating a commodity’s price to decline.
• The terms are apt to confuse even those with some Wall Street experience, but understanding them is vital for investors in commodities.

However, they will generally follow the spot and futures prices while seeking to achieve the best cost efficiency. Some producers may believe that the spot price will rise rather than fall over time. Therefore, they hedge by offering slightly higher prices for future contracts to try and influence contango.

Oil, in particular—as well as other energy commodities—is subject to a backwardation term structure because short-term supply fears have a tendency to drive up the spot month price. These factors could include weather issues or political instability in the Middle East. Precious metals are less likely to suffer from backwardation, since supply is generally not subject to interruption as energy commodities are.