Contango Meaning

Explanation

The Equation term can be quoted as-

Ft > St

Where,

  • Ft denotes Futures Price andSt denotes the Spot PriceSpot PriceA spot price is the current market price of a commodity, financial product, or derivative product, and it is the price at which an investor or trader can buy or sell an asset or security for immediate delivery.read more of the underlying assetUnderlying AssetUnderlying assets are the actual financial assets on which the financial derivatives rely. Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates.read more.

The point arises why markets remain in ContangoContango, i.e., spot prices are lower than forward prices. Major reasons that contribute to the same are enumerated below:

  • Markets expect rising prices in futures of the said underlying asset.Convenience Yield is lower than interest rates.Demand for the underlying asset and seasonality effects also affect and contribute to this impact (This is especially prevalent in the case of commoditiesCommoditiesA commodity refers to a good convertible into another product or service of more value through trade and commerce activities. It serves as an input or raw material for the manufacturing and production units.read more such as fuel, etc.)

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Example of Contango

In the practical world, most futures contracts are undertaken with the intent to settle them on or before expiry on a cash basis with no real exchange of assets through delivery, making understanding it even more important.

XYZ Portfolio managerPortfolio ManagerA portfolio manager is a financial market expert who strategically designs investment portfolios.read more had entered into a futures contract of crude oil when the futures price of June 2019 expiry was quoting at $65. The spot price at that time was $63.50. Therefore futures were trading at a premium of $1.50 over the spot price, and as such, the market is in ContangoContango (Futures Price is higher than Spot Price). At the end of the month, XYZ decided to roll over the futures contract to July month; however, at that time, the spot price was trading at $65, and the futures price was trading at $66. Therefore futures were trading at a premium of $1.Due to the reduction in premium price from $1.5 to $1, the portfolio manager will suffer a loss on roll return as stated below:

  • Roll Return = (June Futures Price-July Futures Price)/June Futures Price= ($65-$66)/$65= (1.54%)

Thus there is a negative roll return when the market is in ContangoContango.

Similarly, suppose the futures price for July was quoted at $64 and, as such, the market is backwardationBackwardationBackwardation is a situation when the futures price of a commodity is lower than the spot price today. It is a rare situation and doesn’t last long. However, the commodity’s spot price can be high due to the sudden rise in demand or a disaster triggering the demand.read more (Spot Price is higher than Futures Price). In that case, the portfolio manager will gain on rolling of its position as stated below:

  • Roll Return = (June Futures Price-July Futures Price)/June Futures Price= ($65-$64)/$65= 1.54%

Thus there is a positive role return when the market is in backwardation.

Difference between Contango and Backwardation

It is important to note that just like Contango differs from “Normal Contango.” A Normal Contango refers to a situation in which the futures price is greater than the expected spot price.

Conclusion

Understanding whether a market is in Contango or Backwardation enables traders and investors to make their bets in futures correctly. Derivative bets undertaken should take into consideration the impact of futures prices accordingly. It enables markets to interpret that the demand for the underlying asset is expected to rise. It also leads to negative rolling returns as futures prices are always higher than the spot prices resulting in rolling costs for each monthly rollover.

This has been a guide to What a Contango is & its Definition. Here we discuss key differences between Contango and Backwardation along with important points, examples, advantages & disadvantages. You can learn more about it from the following articles –

  • Backwardation vs. ContangoMarket Price ExampleDerivatives in FinancePresent Value