A situation 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.
Is it bullish or negative to be in contango?
Futures trading is all about predicting commodity prices in the future. It is necessary to comprehend some technical concepts that relate futures prices to current spot prices in order to trade futures efficiently. Contango is one of these terms.
Contango describes a situation in which an underlying commodity’s futures price is higher than its current spot price. Contango is a positive indicator since it indicates that the market anticipates the underlying commodity’s price to rise in the future, thus investors are ready to pay a premium for it now. In the case of gold, for example, if the spot price is $1860 and the futures price is $1950, the commodity is said to be in contango.
Is gold normally in a state of contango? The answer is a resounding affirmative! In fact, most commodities are in a state of flux. Carrying costs are frequently related with the premium paid above the current spot price.
Costs such as storage or warehousing, insurance, and interest on money related to the product are examples. This is why commodities like gold, for example, are always offered at a premium in the futures market. As the maturity date approaches, the forward price of gold in contango tends to converge lower toward the commodity’s future spot price. Backwardation, on the other hand, occurs when the forward price of gold converges higher towards the predicted future spot price of gold at maturity.
Contango has appeared in the markets several times throughout history. Consider the oil price fluctuations from the 1970s to the 1980s. Oil was priced around $100 per barrel in mid-1980, but by early 1986, it had plummeted to under $25 per barrel. The commodity was priced at roughly $14 per barrel in late 1998, but by mid-2008, it had risen to around $140 per barrel. Since then, there have been more swings, and the commodity now trades in the $45$55 per barrel range as of December 2020.
The aforementioned price variations explain why market participants are eager to engage in market contango. It gives businesses a one-of-a-kind opportunity to shield themselves against the market’s unexpected commodity price swings, which may wreak havoc on their bottom line. For example, airline businesses commonly acquire oil futures to add consistency to both their business model and their returns. It would be devastating if these corporations bought oil at market prices when they were needed. These businesses would almost certainly fail at some point. Companies can prepare for steady prices for a set period of time by purchasing futures contracts.
Market participants adjusting their portfolios can have a long-term impact on asset prices. When futures contracts are purchased, demand rises, causing short-term prices to rise. However, because the market is now swamped with future supply, prices have fallen, thus eliminating contango from the market. Backwardation can occur as a result of this, which many financial analysts and professionals feel is the norm in commodities trade. When futures prices are lower than current spot prices, this is known as backwardation. This is a common scenario for perishable items, and it results in future demand exceeding supply, resulting in higher pricing. However, for non-perishable items with significant carrying costs, the consensus is that buying call options in the futures market is a terrific opportunity. Contango is becoming increasingly widespread as a result of this.
What is the best way to trade contango futures?
Investing in a Spread Trade A spread trade is another option for traders to profit from a contango market. Returning to the example, suppose a trader believes the current price of oil will fall even further in comparison to the next month’s contract. A trader would sell the spot month contract and acquire the next month’s contract.
What factors determine if a future is in backwardation or contango?
- When the futures price is higher than the predicted future spot price, it is called contango. A normal futures curve is frequently confused with a contango market.
- When the futures price is below the predicted future spot price, this is known as normal backwardation. An inverted futures curve is frequently confused with a typical backwardation market.
- If futures prices are higher at longer maturities, the market is normal; if futures prices are lower at longer maturities, the market is inverted.
What is the meaning of contango?
The term is thought to have arisen in 19th century England as a corruption of “continuation,” “continuous,” or “contingent.” Contango was once a fee paid by a purchase to a seller on the London Stock Exchange when the buyer desired to prolong settlement of a trade they had committed to. The accusation was based on the seller not being paid the interest he had foregone.
Normally, the goal was speculative. Settlement days were set in stone (fortnightly, for example), and a speculative buyer did not have to take delivery or pay for stock until the next settlement day, at which point they may “carry over” their position to the next by paying a contango fee. This approach was popular before 1930, but it became less common after the reintroduction of choices in 1958. It was widely used on various markets, including the Bombay Stock Exchange (BSE), where it is still known as Badla. The BSE has replaced the forward trade, which comprised variable contracts, with futures trading based on defined lot sizes and fixed settlement dates.
Why is oil in a downward spiral?
When immediate crude oil prices fall below those further out in the future, the market is said to be in contango. There are futures contracts for each month that are set to expire in a number of years. These values reflect the market’s current and future oil price estimates.
These points form the oil price ‘curve’ when plotted in a chart with time on the x-axis and oil prices on the y-axis.
A simple plot of current oil prices by month (including the recent bounce) yields the following curve:
Contango is common for non-perishable commodities with a cost of carry, such as crude oil and merchandise.
Storage fees and interest on money held in inventory are examples of such expenses.
Why are Bitcoin futures in a downward spiral?
Because there is no cap on futures open interest, futures in contango signal that Bitcoin supply is plentiful, according to Steve Sosnick, chief strategist at Interactive Brokers.
Is contango beneficial?
- A situation 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 scenarios.
- Advanced traders can profit from contango by employing arbitrage and other tactics.
- Contango usually results in losses for investors in commodity ETFs that use futures contracts, but these losses can be avoided by investing in ETFs that contain actual commodities.
Is USO in a downward spiral?
“It tells me that individuals are always looking for a quick profit,” said Astoria Portfolio Advisors’ chief investment officer and founder, John Davi. He was alluding to individual investors who lost a lot of money by investing in this well-known exchange-traded fund, which goes by the acronym USO.
The USO is a long-term investor in oil futures contracts. Oil was in contango, which meant that futures contracts were more costly than front-month contracts, guaranteeing that investors would lose money over time.
Investors lost a lot of money when the gap between the front-month contract and the contracts further out reached an absurd level.
For years, the risks of engaging in these types of futures contracts have been understood. Despite this, a wave of ordinary investors have poured money into the USO in recent weeks, boosting its assets under administration.
“It’s natural that people will want to bottom-fish,” Davi said, noting that investors thought they were buying a product that followed the spot price of oil when they actually bought a product that tracked the spot price of oil.
What exactly is a contango bleed?
Futures markets can act in a variety of ways. When a market is in contango, it signifies that a futures contract’s forward price is greater than the asset’s spot price. Backwardation, on the other hand, occurs when the forward price of a futures contract is lower than the spot price.
When the market is in contango, futures contracts are trading at a higher price than the current spot price. Physical products requiring storage, insurance, and a variety of other considerations could all contribute to this. Bitcoin is a non-physical asset that has been in a state of contango for some time.
The fees that futures ETFs must incur to renew, or roll, their futures contracts are referred to as contango bleed. If the futures contract price is higher than the expiring contract price, the ETFs lose a small amount of money each time, which mounts up over time.
What causes a futures market to transition from backwardation to contango?
The futures contracts are trading at a premium to the spot price, indicating that the market is in contango. Because of basic considerations such as storage, finance (cost to carry), and insurance costs, physically delivered futures contracts may be in a contango.