The phrases “contango” and “backwardation” are used in the futures market to describe whether a significant asset’s delivery price is higher or lower than its current spot price. It helps traders and institutions decide whether to buy a financial product at a spot price or via future delivery contracts.
While commodity traders used the futures or forward markets to sell their product at a future date and lock in the current price, not everyone who trades the futures and commodities markets intends to own the product they are trading. A retail trader, for example, can buy a crude oil futures contract without having to take delivery of 1,000 barrels of oil. Instead, they can trade for profit potential, the difference between the opening and closing contract prices.
Traders who understand contango and backwardation can make better trading decisions because they can see how spot prices connect to future prices, often known as the futures curve. Here’s where you can learn more about forwarding trading.
What does it mean to be in contango?
When a commodity futures price is higher than the spot price, it refers to as contango. Consider the current spot price of Brent Crude Oil, which is $70 per barrel. If you buy a two-month-old futures contract and the holder of that contract receives their oil but has to pay $75, the market is in contango. The forward contract’s cost is higher than the spot price or the indicated future price.
As the contract approaches its expiration date, it will climb closer to the spot price. As a result, unless the price rises above the price paid, the contango contract’s value will decline until it reaches the spot price at expiration. If the spot price remains unchanged, the contract bought for $75 will be worth $70 when it expires. The futures curve is what it’s called.
What is the source of contango?
Contango occurs when future prices are higher than current prices due to supply and demand. Market traders may believe that the spot price will rise in the future, making it worthwhile to lock in a price now, even if it is higher than the current spot price.
The “cost of carrying” can also create contango. Because the product cannot be stored, you may pay a higher price for a product that will not deliver for several months. Instead, you’re effectively paying the individual who sold you the contract to store your things. As a result, there is a carrying cost in the form of a higher-than-spot price.
The derivative products allow you to speculate on the price movements of the underlying forward contract, so you don’t have to worry about taking possession or storing your actual asset when spread betting or trading CFDs. It means you can enter a trade based on whether you believe the asset’s price will climb or fall, resulting in profits or losses depending on whether the market moves in your favor.
Contango in Crude Oil
Due to the cost of carrying crude oil, Brent and West Texas are frequently in contango. It needs to be stored. The cash price of Brent Crude Oil shows in the chart below. The black line represents the price of crude for a three-month contract. Contango occurs when the forward contract is persistently higher than the cash price. The cash price was 40.414 at the time, and the forward price was 40.82.
Silver Contango
The silver chart below shows another example of contango. It shows the cash price and the two-month forward contract price, with hourly closing prices. The futures contract trades at a higher price than the spot price during this time, indicating that the market is in contango.
Explained: Backwardation
Backwardation occurs when the spot or predicted spot price is lower than the future or forward price. Consider the current spot price of crude oil, which is $90 per barrel. The market is in backwardation if you buy an oil forward contract that expires in two months and the holder of that contract receives their oil and has to pay $85 because the future delivery price is lower than the current spot price. As the contract approaches its expiration date, it will climb closer to the spot price. As a result, if the spot price remains unchanged, the $85 will rise to $90.
Gasoline Backwardation
When the prices of futures contracts are lower than the cash spot price of gasoline, it is said to be in backwardation. The chart and price levels below demonstrate how this can happen. The cash price is 1.1226, while the forward contract price is 1.1201 a month later. The further away you go, the lower the prices become. According to the chart, the backwardation was more severe in the past. The cash and November prices have converged at the chart’s extreme right.
Backwardation of Natural Gas
It’s common to see backwardation in the natural gas market. There are times when some contracts are less in contango than others, resulting in backwardation.
Let’s say the current natural gas spot price is $2.85. A month later, the price is 3.02, then 3.25, 3.37, but suddenly it reduces to 3.29, which is less than the previous month. 3.21 comes after that. Because the price is continually declining, these later contracts may be going for backwardation. Backwardation is not present in this price market because forward contracts value higher than spot prices. However, if the spot price is 3.37 in January and February and March contracts price below that, backwardation will exist.
Backwardation of Gold
Gold, like silver and natural gas, is rarely in a backward state. Investors pour money into actual gold and gold stocks and ETFs, enhancing its overall value. However, because gold trading links to the US dollar, interest rate fluctuations in the currency can quickly push gold into contango or backwardation.
Backwardation vs. Contango
Backwardation occurs when futures prices climb toward the spot price over time, and contango occurs when futures prices fall toward the spot price over time. Contracts in contango are biased downward, whereas those in backwardation are biased upward. When the contract expires, both spot and futures prices converge.
These biases affect the contracts themselves in both cases, and they may or may not have anything to do with the commodity’s overall price trend. When a forward contract is in contango, it does not mean that the price of a commodity will decline; it means that the price of a significant contract may fall to equal the spot price or that the spot price may climb.
Contango and backwardation are market circumstances that can change. The market might go from backwardation to contango. If conditions change rapidly, a trading strategy indicated on a significant condition may become unprofitable.
Futures on Contango
Contango futures, as well as backwardation, are popular ways to trade the condition. Futures and forwards are two very similar items. A forward contract is an agreement between two parties, such as a trader and a financial broker, whereas a futures contract trades on trading, with the exchange matching the buyer and seller.
How can you profit from backwardation?
Although most traders prefer to trade contango, there are ways to profit from backwardation also. Backwardation occurs when the futures price is higher than the spot or cash price. In this case, a trader could buy a futures contract hoping that it will rise to meet the spot price. It can be profitable if the commodity’s price is rising.
However, if futures prices are lower than expected, this could indicate that traders anticipate less demand for the commodity. If the price chart confirms this by displaying a downward trend, the trader may wish to sell the commodity or futures contract in anticipation of lower prices in the future.
Profiting from backwardation is more complicated than it appears, and it does not solely depend on whether you should buy or sell the asset. Also, evaluate the commodity’s forecast and trend, such as the degree of backwardation.
How do traders utilize backwardation and contango?
Contango and backwardation are terms used by traders to compare the current futures price to the expected spot price of a commodity at delivery. This information can assist a trader in determining whether to go long or short based on whether they believe the futures price will rise above, fall below, or meet the spot price as the delivery date approaches.
Regardless of whether the market is currently in contango or backwardation, the futures price expects to converge on the spot price as the futures contract approaches its delivery date. If this is not the case, and the futures price remains above or below the expected spot price at delivery, the underlying market offers an arbitrage opportunity.
The Importance of Contango and Backwardation for Traders
Even if you do not trade futures contracts, contango can have an immense impact on ETFs that track commodity futures. Contango ETFs on the VIX, crude oil, gold, and even the S&P 500.
However, several instruments like VIX products and leveraged ETFs claim the objective is to match the one-day performance of the underlying index or commodity. To maintain an average inventory for 30 days in a normal contango market, an ETF will buy forward month futures while selling spot or current month contracts. To replace the lower-priced futures, ETFs buy higher-priced futures. During contango periods, this decays. It is why low volatility leveraged ETFs like UVXY tend to lose eight to 13% monthly. Long-term investors should never own these ETFs due to time decay.
Affects ETFs
Extreme contango and backwardation might result from ETF products malfunctioning and breaking. Investors and traders witnessed an unusual incident on April 23rd, 2020, when May crude oil futures went negative the day before expiration, dropping to negative $34 per barrel.
Due to COVID-19’s worldwide demand freeze and oversupply, buyers refused to deliver and take due to storage carry costs. The buyers went not provide the oil, resulting in a negative contract price. Due to the high contango, the widely held United States Oil Fund (NYSEARCA: USO) ETF collapsed and malfunctioned. The long-term effect is not just a loss of value but also a loss of faith in widely held ETF products as investors rudely awakened to the true nature of their holdings.