Contango

Contango refers to a situation where the price of a commodity or security in the future (known as Futures Price) is more than that of such commodity or security at present (known as Spot Price). It is normal for financial instruments to be in contango as future prices should trade at a premium to spot prices to take care of various factors such as risk-free rate, convenience yield, etc.

A contango share price denotes a normal market scenario where longer-dated securities trade higher than shorter-dated securities. Experts of the market and traders use arbitrage and other such strategies to make gains from such situations in the market. The losses in commodity ETFs that use futures can be countered by investing in funds that hold actual commodities.

• Contango refers to a situation in which the future prices of commodities or securities are higher than the current prices. This phenomenon is common in financial markets, where longer-term assets are often priced higher than shorter-term securities.
• Contango is different from a "Normal Contango," which occurs when the futures price exceeds the anticipated spot price.
• Distinguishing between backwardation and contango in a market is valuable for investors and traders to make informed decisions. It can provide insights into demand predictions and influence derivative strategies. 

Contango is a situation where the futures prices of a commodity are trading at a higher rate than the spot price. In other words, the price of the security at a future date is greater than its current price.

In most future market trades, the future price tends to move toward the spot price when the deal moves toward its expiration date. The opposite scenario is usually referred to as backwardation.

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.

To simplify the concept of a contango trade, let us frame it into an equation.

The Equation term can be quoted as-

Ft > St

Where,

• Ft denotes Futures Price and
• St denotes the Spot Price of the underlying asset.

The point arises because markets remain in Contango, 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 commodities such as fuel, etc.)

The following chart can help traders get a basic idea of the contango concept:

Source

The upward-sloping blue line represents contango. It acts as a bullish signal for traders, indicating that holding onto or entering a buy position could be a prudent decision at the current spot price. The reason behind this is that the strike price of the contract is anticipated to rise in the future.

If individuals wish to develop a better understanding of this concept, they can consider looking at similar charts on the TradingView platform.

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. Let us understand the intricacies of contango stock prices with the help of a couple of examples.

Example #1

XYZ Portfolio manager 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 contango.

Similarly, suppose the futures price for July was quoted at $64 and, as such, the market is backwardation (Spot Price is higher than Futures Price). In that case, the portfolio manager will gain on rolling off 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.

Example #2

The copper prices plummeted continuously in 2023. As a result, China’s economic rebound had faded down significantly. The prices went below the key $8,000 per ton mark for the first time in decades.

The contango spread in 2023 was the widest since 1994. Since this bearish indicator shows that the process is most likely to fall further to a certain extent, the demand for copper went down as well as large manufacturers using copper decided to wait for the prices to fall further before purchasing for their factories and production.

Rightfully so, the prices fell by another $66 per ton.

Since contango share prices indicate the movement of the stock, traders execute strategies to benefit from these indicators. There is no particular strategy used by all traders that guarantee gains. However, the strategy below is widely used and mitigates a certain level of risk and losses.

A trader can short their month contract and purchase the further out month. Therefore, if the market value improves, the trader could benefit from its gain. However, the trader might lose money if the market dials back into a normal backwardation.

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

Both Contango trading and backwardation have been topics of discussion almost simultaneously. There are differences in their fundamentals and what they indicate. Let us understand their differences through the comparison below.

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. Contango
• Market Price Example
• Derivatives in Finance
• Present Value